Ignoring the deflation danger for the banking systems of southern Europe has reduced the latest stress test to another 'farce', says EU economist Philippe Legrain
By Ambrose Evans-Pritchard, International Business Editor
7:35PM GMT 27 Oct 2014
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Monte dei Paschi is the world's oldest bank, dating back to 1472. It is now battling for its life Photo: Alamy
George Magnus, senior advisor to UBS, said it was a “huge omission” for the European Central Bank to ignore the risk of deflation, given the profoundly corrosive effects that it can have on bank solvency. “Most of the eurozone periphery is already in deflation. They can’t just leave this out of their health check. It is a matter of basic due diligence,” he said.
The ECB’s most extreme “adverse scenario” included a drop in inflation to 1pc this year, but the rate has already fallen far below this to 0.3pc, or almost zero once tax effects are stripped out. Prices have fallen over the past six months in roughly half of the currency bloc, and the proportion of goods in the EMU price basket in deflation has jumped to 31pc.
“The scenario of deflation is not there, because indeed we don’t consider that deflation is going to happen,” said the ECB’s vice-president, Vitor Constancio.
The ECB had vowed to be tough in its first real test as Europe’s new super-regulator, promising to restore credibility after the fiasco of earlier efforts by the European Banking Authority in 2010 and 2011.
The aim is to clean up the financial system once and for all, hoping that this will create more traction for the ECB’s mix of stimulus measures. Yet the bank has to walk a fine line since tough love would risk a further contraction of lending, and possibly a fresh crisis.
Independent experts say the ECB has greatly under-played the threat of a serious shock. A study by Sachsa Steffen, from the European School of Management (ESMT) in Berlin, and Viral Acharya, at the Stern School of Business in New York, calculated that the 39 largest European banks would alone need up to €450bn in fresh capital. “The major flaw in the ECB test is that they don’t allow for systemic risk where there are forced sales and feedback effects, which is what happened in the Lehman crisis,” said Professor Steffen.
Their study looked at levels of leverage rather than risk-weighted assets, which are subject to the discretion of national regulators and can easily be fudged. Most Club Med banks can defer tax assets, for example.
The ECB ordered Monte dei Paschi di Siena, the world’s oldest bank, to raise €2.1bn to cover losses from derivatives trading and the disastrous legacy of a takeover deal in 2008. The bank said it is exploring “all strategic options”, a hint that it may soon be forced into a merger.
Andrea Filtri, from Mediobanca, said Italian banks has been hit by “asymmetric treatment”.
The adverse scenario for Italy’s GDP was a fall in 11.6pc from 2007 levels, compared with -7.6pc for Spain and 0.8pc for France. The economic justification for this is obscure. By contrast, French and German lenders escaped unscathed. The German Sparkassen savings banks with €1 trillion in assets were not even tested. Bancassurance was treated far more lightly than under the UK tests. Litigation risk was not covered.
Professor Steffen said German and French banks would incur the biggest losses by far in a real crisis, a risk entirely missed in the ECB tests. He said there is no comparison with the sweeping tests by the US authorities in 2009. The US Treasury forced banks to raise more capital whether they wanted to or not. Europe’s regulators have instead given them the option of slashing their balance sheets, exacerbating the credit squeeze in southern Europe.
Philippe Legrain, a former economist at the European Commission, said national regulators have been “captured” by the banks, and collude with them in hiding problems. While the ECB is theoretically better, it is under the thumb of Germany and France, explaining why the only sacrificial victims were minor banks in “less politically powerful” countries. “The ECB is deeply compromised,” he said.
Mr Legrain said the failure to stress test for deflation is a grave error. “Given that it would wreak havoc with banks’ balance sheets, it is a farce. Deflation raises real interest rates and it raises the debt burden,” he said.
Even “lowflation” of around 0.5pc is already causing debt ratios to shoot up across southern Europe, rising by 5pc of GDP each year in Italy despite a large primary surplus. A deflationary trap would revive fears of a debt crisis in these countries, with contagion effects for banks holding government bonds. The “vicious circle” between the states and banks remains despite talk of a banking union.
“It is very telling that the ECB chose to ignore deflation because they themselves are responsible for it,” said Professor Richard Werner, from Southampton University and a former adviser to Japan.
“What we learned in Japan is that deflation automatically leads to bankruptcies because nominal GDP is shrinking. Japan had 20 big banks in 1990 and now it has three. Deflation was the mechanism that brought this about. The ECB is following exactly in the footsteps of the Bank of Japan,” he said.
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