Forget the stress tests: Europe’s banks are a worrisome mystery

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Investors could soon start looking to Frankfurt, the home of the European Central Bank, to shore up confidence in euro zone banks.
Investors could soon start looking to Frankfurt, the home of the European Central Bank, to shore up confidence in euro zone banks.
Image: IK's World Trip on Flickr

Revelations on Sept. 28 that Spanish banks need almost €60 billion ($77 billion) to avoid going bust in the event of a severe Spanish recession seemed, at first, like relatively good news: It was slightly less than previously thought. But investors are worried that the “stress tests” that produced this figure, like many others performed on European banks in the last two years, may actually be close to worthless.

The stress tests (pdf) essentially look at the share of a bank’s loans that would go bad in the event of recessions of varying severity, and calculate what that would cost the banks. As a rule, the tests don’t take into account a bank’s foreign assets, fixed income and equity portfolios, and sovereign debt, because the values of these assets can fluctuate, making them hard to gauge. But since the current likely cause of a recession is a sovereign default, analysts are arguing, it’s impossible to know what kind of stress a bank could withstand one without such data.

And the shortcomings of these Spanish bank stress tests are merely emblematic of a larger European problem. Banks have been pushed to increase the quantities of “core”—or highest-ranked—capital they hold in order to perform better on stress tests. Supposedly, this capital is risk-free, or “zero-risk-weighted.” However, such holdings—particularly of government bonds—do have some inherent risks, writes Lombard Street Research’s Leigh Skeene in a note on Oct. 1:

Risk weighted capital is an accounting artifice. It has no substance, so can’t absorb losses. All banks have dedicated loan loss reserves that can. The only other buffer for losses on bank balance sheets is net tangible equity (NTE). The Deutsche Bank balance sheet for June 30, 2012 illustrates the abysmal inadequacy of some European bank NTE to absorb losses. It reported €2.24 trillion of assets, €372.6 billion of risk weighted assets and €38 billion of capital, giving an apparently comfortable 10+% equity ratio. But what about the other 83% of the bank’s assets that are zero risk weighted?

Leveraging Basel zero risk weightings on Eurozone sovereign bonds to absurdly high levels caused the current Europe financial mess. European problems make it obvious the €1.86 trillion of zero risk weighted assets contain some hidden sovereign risk, counterparty risk, market risk or liquidity risk. The equity buffer for those losses plus the losses on the admitted risk assets after deducting intangible assets from both sides gives an NTE [net tangible equity] ratio of 1.4%, little more than a fifth of the minimum safe level.

In other words, European stress testing and calls to raise capital have convinced no one that European banks are truly stable, because they make troubling assumptions about the safety of that capital. What regulators get, then, are numbers they want to see rather than the numbers that really exist—and that’s frightening to investors.

While many investors are still worried that a country like Spain or Italy could be forced to default, the prospect of a banking crisis is more alarming. As we saw last fall, concerns about funding problems escalate quickly: doubts placed in one major bank or banking system have a way of turning into fears about the entire system, leading lending to tighten up, and increasing the price countries have to pay to borrow funds on the open market. The resounding lack of faith we’ve seen in these stress tests is disturbing, if only because it hints that focus is turning back to the banks—and the picture is a murky one.