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The Failure of Europe's Stress Tests

Mark Whitehouse writes editorials on global economics and finance for Bloomberg View. He covered economics for the Wall Street Journal and served as deputy bureau chief in London. He was previously the founding managing editor of Vedomosti, a Russian-language business daily.
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Later this week, European regulators will report on stress tests designed to determine whether the region's banking system could withstand a crisis. Judging from a separate indicator of financial strength, the truth is probably more than they can handle.

QuickTake Stress Tests

The tests will focus on 51 banks in the European Union and Norway, subjecting them to an adverse scenario including a protracted recession and a sharp decline in commodity prices. The exercise is expected to be particularly unpleasant for Italy, highlighting the troubles of banks -- such as Monte dei Paschi di Siena -- that the government has been struggling to salvage.

That said, as they have in the past, the tests will probably fall short of revealing banks' true vulnerabilities. Authorities have little incentive to be tough: The rules of the EU's banking union severely limit their ability to recapitalize weak institutions, so flunking a lot of banks could trigger panic rather than catalyze the desired healing process. This time around, the tests won’t even indicate which banks passed or failed.

To get a sense of what a real stress test might look like, economists at the University of Lausanne's Center for Risk Management have built their own reduced-form exercise, borrowing a model developed at New York University. Using publicly available data on banks' balance sheets and share-price volatility, it estimates how much added equity financial institutions would need to avoid distress in a crisis.

For a group of more than 100 European financial institutions (including insurers and real estate firms), the estimated capital shortfall stood at 1.2 trillion euros ($1.3 trillion) as of June 30. It hasn't improved much since the darkest days of the financial crisis in 2009, and rose sharply around Britain's vote to leave the EU last month. Here's how that looks:

Capital Inadequacy
 
Source: Center for Risk Management, Lausanne

And here's a breakdown of the estimated capital shortfalls, as of July 15, for selected banks participating in the European stress tests:

What to do? Actually, if European regulators hadn't spent the last several years largely ignoring the weaknesses of the region's banks, they could have achieved a lot. Since 2007, the 40 euro-area banks in the Euro Stoxx Banks Index have given about 400 billion euros back to shareholders in the form of dividends and stock buybacks -- money that could have gone toward bolstering their capital positions. Instead, regulators are actually moving in the opposite direction: The Bank of England announced earlier this month that it would ease capital requirements in the wake of the Brexit vote.

This regulatory meekness helps explain the European economy's lackluster performance. As researchers at the Bank for International Settlements have demonstrated, better-capitalized banks tend to borrow at better rates and lend more, improving the effectiveness of central banks' efforts to stimulate growth. In other words, if authorities had acted faster to shore up the financial system, the European Central Bank might not be having such a hard time getting the economy out of the doldrums.

Avoiding the truth has consequences. If Europe's leaders want to get their financial system and economy out of the mess they're in, a reckoning is long overdue.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

To contact the author of this story:
Mark Whitehouse at mwhitehouse1@bloomberg.net

To contact the editor responsible for this story:
James Greiff at jgreiff@bloomberg.net