The European banking assessment results, released yesterday, were generally well received by markets. The test looked like earlier U.S. and Spanish stress tests in terms of structure, the results were in line with market expectations, and the report provided enough detail to keep analysts busy for weeks. This morning, the euro is firmer and European stocks were up a bit before weak data clawed them back. Will this test succeed where previous efforts have failed and ultimately restore confidence in European banks? I suspect that your answer to this question depends on your outlook for the European economy. Without growth, Europe remains over-indebted, its banks undercapitalized, and a crisis return looks likely.
European Central Bank (ECB) led the review and identified a capital shortfall of €25 billion at 25 banks, which was reduced to €9 billion (13 banks, none designated as systemically important) after taking account of capital raised so far this year. Italian and Greek banks had the most problems, unsurprisingly. Assuming promised remedial actions fill about half of the remaining gap, the remaining capital shortfall is a modest €4.2 billion at only 8 banks, according to Morgan Stanley. However, using new, tougher capital rules (e.g., on goodwill and deferred tax assets) that will go into effect in the next few years raises the “fully-loaded” capital hole significantly and as many as 35 banks would have failed, according to several market analysts.
The capital hole reflects a cleaning up of the balance sheets and a stress test, in roughly equal measure. The asset quality review (AQR) at the core of the exercise identified valuation problems at 130 banks, resulting in a markdown of the balance sheet by €48 billion. The ECB blamed poor valuation of commercial loans for much of the problem. It further criticized national regulators for underreporting non-performing loans (NPL) by €136 billion. That is a huge number, though on the positive side the move to a common, accepted standard for NPLs across the euro zone is a encouraging step.
The stress test that was then applied to these cleansed balance sheets was a shock that depleted banks’ capital by €263 billion, reducing core capital by 4 percentage points from 12.4% to 8.3%. By comparison, the hit to capital in the well-received earlier Spanish stress test was 3.9 percent.
Many analysts, including Nicolas Veron, argue that the exercise overall passes the smell test (though noting that we need to wait for the bank’s own reports next year to know for sure), while Philippe Legrain argues that it’s a whitewash. I have some sympathy for Legrain’s argument—the review covers less than half of risk weighted assets, in part because it did not address problems at smaller banks (around 20 percent of euro area assets), notably German savings banks, and the macro stress test looks less stressful now (in light of weak recent data) than it did when they decided on it. The stress test does include serious market and growth shocks (though not litigation costs that are likely to be a material headwind for the major banks). However, the inflation numbers in the stress test are above current levels, which seems surprising given broad concerns about low inflation (if not deflation) in the euro zone. This suggests that the macro scenario is faulty if very low inflation creates a risk to bank balance sheets beyond the conventional stresses that were addressed.
The bottom line is that those of us that have been critical of Europe’s macro policies, and concerned that the baseline growth scenarios are too sanguine, are unlikely to draw much comfort from this stress test. Even a successful stress test is unlikely to restart the flow of credit quickly. Europe remains too bank-centric, too little is being done to restart credit to small and medium enterprises, and broader demand support is needed. Absent these moves, inadequate monetary and fiscal policies may quickly render this stress test, like the earlier ones, unconvincing.