Did The European Central Bank Pass Its Stress Test?
Oct. 27, 2014 6:56 AM ET
Summary
- The current round of bank stress tests is Europe was as much a test of the European Central Bank as it was a test of the condition of the banks.
- In this respect it seems as if the ECB passed the current round of stress tests.
- This is very important because the next step on the way to European political union is the creation of a workable banking union.
Stress testing banks can only go so far. The validity of stress tests depends upon their assumptions and, as many people know, what you assume can result in what people eventually think of "U" and me.
In this respect, it appears as if the European Central Bank has passed this round of stress tests.
It is very important that the ECB passes this test because Europe is moving on to a banking union to augment its money union, which will someday…hopefully…be completed with a political union.
One step at a time.
Well, only 25 banks of the 130 banks examined were identified as not passing the stress test and, of these, only 13 banks were considered to be "sick" banks. The "really sick" banks were even fewer.
And, as many analysts claimed, the concern was even smaller because most of these organizations have already done something about their balance sheets and capital positions since the end of last year since the stress test was applied to the condition of the banks as of the end of 2013.
I think that the most significant aspect of this exercise is the movement to get the European banks to "come clean." That is, European banks have been notorious for their unwillingness to open up their books. As a consequence, no one really knew where the banks were in terms of the quality of their assets and the areas in which problems existed.
If a European banking union is to have any credibility, it must have the ability to understand what is going on within the banking system and to know what is the status of the banks.
In this respect, probably the most important finding of the stress test has to do with the amount of bad loans that exist on the balance sheets of the banks being examined.
The result that I have seen: "the review uncovered €136 billion in troubled loans that banks had not previously reported. Partly as a result, banks had overvalued their other holdings by €48 billion, the central bank said." This reported by Jack Ewing in the New York Times.
In terms of needed capital: "The €25 billion capital shortfall was on the lower end of analysts' estimates."
The bad loan problem…well, I wrote about this last week and quoted Gillian Tett of the Financial Times: "the ratio of household debt to gross domestic product in the eurozone has risen, not fallen, since 2008. Corporate debt has also grown. To a degree that reflects Europe's lack of growth. But lenders have also been painfully slow to resolve bad debts.
That is partly because of unrealistic optimism about the future and a shortage of bank capital to absorb write-offs. But another issue is the legal framework: many parts of Europe simply do not have the mechanisms needed to resolve bad loans quickly."
I added: "What this points to is a need for European banks to clean up their balance sheets. This is something that United States banks have been able to do and is, to me, one of the successful results of the quantitative easing of the Federal Reserve System. In other words, banks in the eurozone are way behind banks in the United States in terms of getting themselves in order."
If the European banking system is to function and if Europe is to recover, the balance sheets of the banks must be cleaned up. And, the first thing that must happen for the balance sheets to be cleaned up is for the banks…and the authorities…to be open and honest about the "bad" loans that are on the books of the banks and to move quickly to take care of the problem.
In terms of completing the re-capitalization of the banks and taking care of merging the remaining "questionable" banks into healthy organizations, that can take place in an orderly manner…given where the banking system seems to be at this time.
Therefore, it seems to me that the ECB has done its job, the initial response to the effort has been positive, and, so far, European stock markets have responded modestly.
So, it seems as if the ECB has passed this stress test. But, it still must move on into the future and this means that it must establish its credibility in completing the European banking union.
To do this, bank reporting must overcome national insecurities and most emphasize being as fully open and transparent as possible. Within such an environment, bank managements must accept the fact that they cannot cover up bad loans and must deal with them in a timely fashion.
Hiding problems and postponing dealing with the problems just strings out a bad situation and keeps the whole system from moving on into the future.
One can certainly argue that the extent to which European economies have failed to recover from the economic dislocations of the past six years has been exacerbated by the failure of the banking system to respond to its difficulties and clean up balance sheets. Banks just don't lend when they, internally, know that they are carrying an excessive amount of bad loans.
The European Union still has to deal with many problems connected with achieving a greater political union, with the current budget battles being only one piece of the puzzle. But, it seems as if the EU is, kicking and screaming, moving into the 21st century. Maybe the successful completion of the current stress test is just another step along the way.
Did The European Central Bank Pass Its Stress Test? - Part 2
Oct. 28, 2014 6:51 AM ET
Summary
- European financial markets seemed to react well yesterday in the aftermath of the results of the ECB's stress test released over the weekend.
- This allows the ECB the opportunity to move on in the quest for a European banking union.
- There is still a lot to do to successfully achieve such a banking union, but financial markets appear to be supportive.
Yesterday, I asked "Did the European Central Bank Pass Its Stress Test?"
My answer to this question is "Yes" it appears as if the European Central Bank did pass its stress test.
The only evidence I have for this conclusion at this time is the reaction of the markets.
Today European markets have all rebounded with futures prices up across the board. In most cases the markets have regained the small amounts that they lost on Monday and then some.
Bond markets seem to be stable with very little difference in pricing, especially for Italian bonds relative to German bunds. And, the yield on the 10-year German bund today is spot on with where it was yesterday.
And, the value of the Euro has gone up modestly…both on Monday and Tuesday.
All-in-all, the financial markets seem to be moving on as if the announcement over the weekend of the results of the ECB's stress tests are a non-event.
In essence, the European Central Bank has gotten through this highly publicized exercise without a major stumble.
Now, European's banking union can move on.
This does not mean that everything is in good shape in Europe. As the comments to the post cited above indicate, there are still many, many problems within the European banking system.
Regulation is still weak, the regulators and examiners, in general, are not the best in the world, bank accounting systems leave a lot to be desired, and bank managements are as likely to push things off and hide things as they are to moving quickly to correct a problem and get troubled assets behind them.
I agree with this…and more.
But, the European banking union is moving on…and with the support of the financial markets.
It is perhaps fortunate that the banking system in Europe is as good as it is. Given the political structure of much of European society, political corruption and political relationships are a big part of what goes on that is called business…especially in countries like Italy, Greece, and Spain.
To get the banks as much as possible out of such a situation is perhaps as important as anything else in terms of correcting and reforming the banking system.
This problem has received a lot of publicity lately as the European Union continues to struggle with France and Italy about its fiscal budgets and the reforms that must be made within their countries if the EU is to move along and if there is any chance for the countries of the continent to achieve some kind of political union.
Certainly the stress test can be highly criticized and torn down. I am not a big fan of stress testing anywhere…even in the United States.
If anything, I believe that the best thing that has come out of the stress tests is the opening up of a bigger window on the books of the banks that were included in the stress tests. I believe that a lot more openness and transparency needs to be achieved in the European banking union…but, then, I believe that the United States banking system must achieve a lot more openness and transparency going forward.
The point is, the European Central Bank got through this potential pothole in the road and so that the banking union can move ahead.
In some sense, it is truly remarkable that the countries in the European Union are as far ahead as they are on monetary union, banking union, and political union. For those that have watched the process over the past twenty years or so, the search for progress can be extremely frustrating as the "leaders" of Europe…and I use that term very loosely…continue to just kick the can down the road on most every issue.
Furthermore, one can say that the EU would be nowhere near where they are now without the financial and economic crises that they have faced over the past seven years.
There are, of course, still many bumps in the road ahead that must be negotiated. The darkest cloud on the horizon is the possible continental recession combined with real price deflation.
Then there is the Russian/Ukrainian situation, then there is the situation in the middle east…and so on…and so forth….
The stress test, test is over. Let's move on and see whether or not the ECB can achieve a further union of the continent's banks.
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