Don’t write off the banking stress tests just yet

It may all sound like the bizarre head clasper pronged on shoppers’ heads by Scientologists in Tottenham Court Road, but stress tests are at least a little more important than that.

Eight European banks failed the EU’s eagerly awaited stress tests. Five in Spain: (CAM, Catalunya Caixa, Banco Pastor, Unnim, Grupo Caja) Two in Greece: (Eurobank, ATE/Agricultural Bank). One Austrian Bank: Volksbanken.

That means the EBA calculated that in a bad economic scenario, those eight banks would end up with core buffer funds, known as core Tier 1 Capital, of less than 5 per cent. In fact one Greek Bank, Agricultural ended up with a figure of minus 6 per cent.

A further 16 banks scraped through the test with capital of between 5 and 6 per cent in the stress condition. From Britain, only RBS came near to failing with 6.3 per cent.

So what does that all mean?

Firstly relief at the 82 banks that passed. Relief in Britain and France. The Chancellor George Osborne helped push through the idea of stress testing last year, alongside US Treasury Secretary Tim Geithner. 

In some ways the tests have already achieved their aim. At the end of last year, there were 12 more banks that would have failed. They were gently incentivised to raise more capital by the threat of being outed. So they did. As one EU official said: “The tests have already had a salutary effect in spurring the banks to do what they should have done.”

So why were the stress tests conducted by the EU’s new European Banking Authority widely written off even before they were published? Irish banks that passed these tests a year ago, were within weeks heading for such a profound level of bankruptcy that they threatened to take the Irish state with them.

Alongside this, among the “stress” scenarios applied to Europe’s banks, the default on Government debt of Greece or Portugal was conspicuously absent. However this time the EBA claims it got hold of thirty times more information, 3000 data points rather than the 100 pieces of information last year’s flimsy effort was based on.

Not just that. The EBA has published 11 pages  of unprecedented disclosures for every bank covered.

“Almost all the banks complained about the degree of disclosure we are putting on the table today,” said the EBA Chair Andrea Enria. 

So whereas it does seem a little daft not to countenance the effect of a sovereign default within the Eurozone, there was far more information in these tests than I expected.

The “90 banks shows the aggregate exposure-at-default (EAD) to Greek sovereign debt outstanding at 98.2bn euro”.

Of that the EBA reports that 67 per cent is held by Domestic Greek banks. Aside from Greece it is German (9 per cent), French (8 per cent) and Cypriot (6 per cent) banks which hold the most Greek government debt. 

British banks hold just 2 per cent. There is a complex matrix of exposures detailed in the pages released today by the EBA. It’s daft to write all that off.

All of this leads the EBA to conclude that “the direct first-order impact [of default], even under harsh scenarios, would primarily be on the home-banks of countries” and that “…the capital shortfall should be easily covered with credible back stop mechanisms such as support packages already issued in Ireland, Greece and Portugal”.

 The conclusion? That banks in those stressed countries should be made even more bombproof than the average 5 per cent applied across the EU. So that means extra capital for PIG banks, when some of them have shown, to the contrary, significant shortfalls.

What does this mean in practice? I would say a massive consolidation of banking, particularly in the Eurozone periphery.

Closures, mergers, takeovers, and possibly further nationalisations. So despite the fact that these “stress tests” fail to include the most obvious cause of stress, I wouldn’t write them off just yet.