Eurozone banks…do we finally know their status?

There is huge buzz around European banks stress test. There have been tests before as well but did not exude enough confidence.

Wharton Prof Richard Herring discusses what is new in these tests and do we finally know the true status of European banks.

The basic complications over who shall fund the bill remain despite ECB coming into the picture now:

So this [stress test] is more of a true exam than a little minor quiz, which seems to be what they had in the past.

Herring: We still don’t know for sure because only time will tell, but there’s every reason to believe it was much more serious. They were very much aware, first of all, that the odds are higher because after this, the ECB owns the problem. So, if you accept a dodgy bank from one of the nation states, there are costs to everybody in the rest of Europe.

Secondly, they were aware of the tendency of a supervisor to perhaps be a little bit gentle with their own supervisees. And so they designed examination teams that included a national supervisor, but also a supervisor from another country and a supervisor that was hired by the ECB. You had essentially three different perspectives and a much greater chance that you were going to actually get it right.

One of the surprising things about the U.S. was when they finally got around to announcing the results of the stress test, we were already in a more stressful macro situation than the [worst case] stress scenario. So that, too, makes it a bit puzzling that it worked. In the European case, people have been concerned that [the test] didn’t consider what many people worry about in looking at Europe, such as a deflationary impact. So there are always issues about that.

But there are also technical issues about the way in which stress was measured. They looked to a definition of capital-to-risk-weighted assets that covered up at least two pretty serious problems. One, they used the definition of capital that included two categories of accounting terms that are no longer accepted internationally. One is they permitted banks to count deferred tax assets. That’s fine if you’re going to make profits in the future. But if you’re a bank that is headed for resolution, that’s not going to be worth anything. And [two,] they also permitted banks to count goodwill. You can ramp up good will however you like by simply overpaying the accountants, and make the charitable assumption that you knew what you were doing.

Knowledge@Wharton: It’s the ultimate asterisk?

Herring: Absolutely. And then the denominator is fudged, too, because they maintain the polite fiction that all government debt is riskless, that it will be repaid in full. Yet, one of the fundamental problems in Europe is that European banks tend to hold large amounts of sovereign debt. And although it’s diminished a lot since the crisis began, there are large amounts of cross border debt. If you assume the Euro’s going to work and that everybody will be repaid, there was a real tendency to put the higher interest rate stuff — that was in riskier countries — in your books.

Well as ECB does not hold govt debt, someone has to. In US Fed can owe the govt debt, so banks can shift to private sector assets. So ECB’s QE shall try and address this problem..

The markets reacted positively but we are still unsure. Markets react to anything and dump the same thing with equal gusto. So cannot take market reaction as a sign of confidence fairy.  So we will have to wait and see:

Knowledge@Wharton: What else should we know about this?

Herring: It all sounds like a within-the-EU kind of issue that is more than a little technical. But we actually do have a lot riding on it. If the European banking system doesn’t regain health, not only is it a problem for our financial system, but it’s a huge problem for the European economy. And they have been a significant source of aggregate demand in the world. We could hope that they would finally get there, not only for their sake but for everybody else’s as well.