Stress Test of the European Banks: The Hidden Surprise

A little over a month ago, European banks had to undergo a stress test to determine how well their capital holdings were structured and to what extent they were dependent on capital tied to volatile countries like Greece, Spain or Portugal. Despite the results being reassuring at first, analysts noticed after a while that there were significant omissions of information in the original reports: the banks’ capital structure is indeed much more exposed to credit risk than was believed.

In July 2010, the Committee of European Banking Supervisors (CEBS) imposed a stress test on all European banks to see whether they were prepared for another potential financial crisis. The test was primarily aimed at measuring the banks’ capital ratios – whether there is enough capital of a good enough quality for the banks to rely on. Several other non-EU countries conducted a similar stress test – LSM Insurance brought an article on the Canadian Insurers Stress Test a few weeks ago as well.

The results of the banks’ test did reveal that a few banks were in a less-than-favourable situation, but the overall results were relieving and helped restore confidence in the European banking system as a whole. For those reasons, the Euro enjoyed a stable position in the currency markets.

That is to say for a little more than a month. Early in September, The Wall Street Journal came with a detailed review of the results, combined with an analysis of the banks’ official financial statements. WSJ’s findings show that the banks did not disclose all the important information about their debt in the CEBS template, as the numbers did not entirely reconcile to their financial statements. The banks did not bluntly lie. They merely neglected to specify the type of their capital correctly, because the requirements were not specific enough either.

Government bonds, once believed to be virtually risk-free, have gained on importance. Greece’s near-bankrupt status puts a much higher risk on their government bonds and as such, they should be recognized in a different category. Many banks did not acknowledge this fact in their stress test report. In addition, some banks simply did not disclose portions of their capital holdings, claiming that those are highly volatile and actively traded. This way, they effectively improved their results in an uncontrollable fashion. Since each bank “understood” the test requirements differently, each bank disclosed its capital differently and rendered the results virtually incomparable.

The main problem with the stress test was how little additional information or explanations the banks provided. It seems that the CEBS test rules were too lenient to force the banks to reveal any usable data. This is unfortunate for the Euro, which suffered a severe hit as compared to other major currencies and has been recovering shakily since. It is only puzzling that despite all the evidence, CEBS is still defending the test rules.

Hopefully, banking regulators will learn from this faux pas and will ensure that any future tests and regulations are reliable and thorough. Any additional issues would considerably harm the credibility of the economy in question.

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