Probably everyone's had a chance to pore over the Committee of European Banking Supervisors' (CEBS') concise(!) summary of the European bank stress tests. But in case you missed it, here's a few thoughts from me.
The stress tests were carried out following general concerns about the health of the banks following the recent financial crisis/recession and mounting jitters that 'someone' in the eurozone (ahem *Greece*) might default on their sovereign debt. If there was a sovereign default, banks exposed to that sovereign debt would incur losses, if high enough potentially collapsing/defaulting on their own debt. Confidence in other risky sovereigns would also decrease, driving up spreads on their bonds, making further defaults more likely. The contagion could transmit another major financial sector shock through the whole European economy and probably the rest of the world as well.
The idea was to simulate a deterioration in economic conditions as well as some kind of increase in sovereign risk, see how the banks' capital ratios respond, and determine if any needed to be recapitalised to be able to withstand such a shock.
So, the results are in and only 7 out of 91 banks 'failed' - meaning they might not have enough capital to cover their losses in the most adverse scenario modelled. Importantly none of the biggest banks failed and national government authorities are in contact with 'the seven' about their relatively modest (€3.5 billion) needs. Overall the European banks' aggregate tier 1 capital ratio would decline to c9% - well above the 6% threshold benchmark for concern in the tests. Case closed? Hmm...
True enough the stress tests have brought out some positives. No. 1 is the increase in transparency of the European banking system. Individual results for each of the 91 banks have been published and, after some initial reluctance from German banks, the banks are now coming forward with their individual exposures to sovereign debt. No 2 is the lack of a major unexpected result - widespread or large scale failures may have prompted calls for further government aid to recapitalise the banks - hardly welcome news as most EU governments are looking to trim budgets, not add to them.
But on the flipside big questions remain.
Were the tests stressful enough? Some analysts are suggesting the 'adverse scenario' was hardly a monster - in fact very pale in comparison to the downturn we've just emerged from with growth flat for 2010 and at -0.4% for 2011. In 2009 Europe contracted by more than 4%. Was this really the 'tail event' CEBS paints it as or is it not so hard to imagine with just a few more wobbles than what we have now?
Also, what about sovereign debt concerns, a big motivation for the stress tests? CEBS claims this was covered off by assuming some hefty spreads on government bonds. The increased spreads mean risky countries have to offer higher interest payments to get people to buy their bonds (relative to German bonds). The banks' are hit in their 'trading books' - the higher spreads indicate higher risk causing the price of bonds they hold for trading from risky countries to decline, the reduction in value known as a 'haircut'.
What was explicitly left out of the tests was any sovereign defaulting. This means that c70% of sovereign bonds - held on banks' 'banking books' - were unaffected by the tests. Bonds on banking books are held to maturity. If we assume that no country actually defaults on its sovereign debt, then there's no loss on the value of these bonds. Why would CEBS make such an assumption and leave out any testing of sovereign default? Because...well, because the Europeans won't let that happen. They've said so, and they've even created the European Financial Stability Fund to stop that happening.
Some cynics might say that the real motivation for leaving out this scenario is because it would've produced many more 'fails'; suggesting major systemic risk; and perhaps become a self-fulfilling prophecy by triggering a panic.
So with some ups and some downs, little market reaction, and some positive recent economic data, can the EU forget about the tests and get on with their economic recovery? Maybe not. Firstly, CEBS itself has said it plans to do more tests 'on a periodic basis' - at odds, it would seem, with the views of some (Germans again).
Secondly, with everyone having been so transparent, the markets now have access to sufficient data to allow them to conduct their own stress tests with their own assumptions. Potentially these could throw up worse overall results and fuel further doubts on the overall health of the European financial system.
Thirdly, and most importantly, the driver of concern on sovereign debt - uncompetitive euro members facing massive fiscal consolildation and weak growth prospects - hasn't gone anywhere. This sort of challenge won't be resolved in the short term either - it will take months and years of grind. The ECB/IMF might have warded off a Greek default, for now at least. But what if a larger country were to get into trouble, would the EFSF be enough?
With Europe such a vital source of demand for our exports and the likely contagion of problems to our own financial system were default to materialise, European stress might be ours too for a little while yet.