Test Stressed

By ignoring much of the potential impact of a sovereign debt crisis on the solvency of Europe’s banks, perhaps the regulators who ran the so-called stress tests released today were trying to send the world the message that they don’t take the possibility of a eurozone sovereign default seriously, and neither should the markets.

In conducting the tests, the Committee of European Banking Regulators and the European Central Bank assumed various haircuts on the values of Greek, Portuguese, Spanish and German debt, but applied these only to the trading books of the examined banks, not to their loan portfolios. In effect, this assumes that the impact of a contemplated crisis will be limited to a short-term liquidity discount on national obligations, but that any bonds held to maturity will in fact pay off in full. Indeed, Bloomberg quotes ECB vice president Vitor Constancio as saying a sovereign default scenario was not included because “we don’t believe there will be a default.”

As a result of this and other arguably dubious assumptions (apparently including parallel shifts in the yield curves of eurozone members – one would think such movements might be quite different for a defaulter as opposed to other euro nations) only seven of the ninety-one banks examined failed the tests and will be required to raise more capital.

Now the eurozone regulators’ gambit only works if the markets are convinced that member nations’ governments really have the will and means to prevent a true sovereign default. In fairness, recent EU and IMF lending initiatives combined with fiscal restructuring in nations including Ireland, Spain and to some extent Greece have lent support to the euro and European debt markets. However, by banishing true sovereign default from their realm of contemplated possibility, the CEBR and ECB have put far more of the responsibility for European (and global) banking stability back in the hands of Europe’s politicians. Banking on the vicissitudes of political capitals as opposed to increased bank capital might itself be a potentially risky move.

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One Response to “Test Stressed”

  1. Tim VH says:

    Yes, indeed.

    The biggest thing that happened last week was the European Central Bank taking its first step towards loss of credibility.

    With both support of this structure of solvency tests and with its shrill Pravda-style lecture about fiscal discipline, the Central Bank has signaled subordination to the political processes in Europe. It’s supposed to be not only independent of them, but above it all.
    These things creep up on you (like technology’s impact on productivity during the mid-80’s through mid-aught’s). Biggest under-reported story of the year so far.

    Here’s a common-sense check: did the macro-economic scenarios of the tests include the ends of the continuum we’ve seen over just the past 5 years?
    Nope, didn’t.
    There was nothing like the slow mudslide of 3 to 5 years of -50bps to -75bps p.a. decline in aggregate price level accompanied with -25bps to -50bps negative annual NGDP.

    Since we didn’t bother to model it, do we expect it be more manageable ( or more interesting) when we find out for real?