The European Banking Authority is responsible for so-called stress testing. What happens if the economy shrinks, the stock markets plunge and so on? It announced today that roughly 90 banks will soon be subject to the latest round of stress testing.
Six things should worry us, however.
First, the assumptions the regulators are making need to be more dramatic. The entire point of a stress test is not to see how you will withstand a mild cold. You want to know whether you'll survive the flu. Crises are like that. The hit hard and fast.
Regulators will look at what would happen if the European economy were to shrink by 0.5% of GDP and if the stock market would decline by 15%. Any noticeable recession takes a couple percentage points off the economy, and the collapse of any large institution certainly would set off a chain of events
Second, the only major shock that the regulators are accepting is a reduction in stock markets. What about the bond markets? What about derivatives markets? These two dwarf anything that the stock market has to offer, and banks are major players. This thinking is far too optimistic.
Third, what about the linkages between other financial market participants and banks? It's a complex financial world out there, with cross-holdings and ownerships and investment positions across banks, insurance companies, unit trusts, hedge funds and other investment houses.
Fourth, everyone is wondering now what the terms of a bailout in Portugal will be, and what the consequences of a debt default in Greece would be. If those positions fail, then there will be major knock-on effects for the banks of countries throughout the EU. Refusing to stress test this is reckless endangerment of the European banking system.
Fifth, the banks still don't like it. Not surprising.
Finally, banks have been making announcements recently that they will raise new capital on markets to ensure that their vaults are sufficiently stocked to get a good review. But if they were doing the right thing in the first place, why would they need to? Banks don't like sitting on their cash. And raising new capital may mean borrowing briefly from other banks, only to pay it back once the inspectors are gone.
Stress testing in the EU has a long way to go before it does more than assuage public fears about banking solvency and liquidity. It needs more robust models and reporting between tests at a minimum.
Six things should worry us, however.
First, the assumptions the regulators are making need to be more dramatic. The entire point of a stress test is not to see how you will withstand a mild cold. You want to know whether you'll survive the flu. Crises are like that. The hit hard and fast.
Regulators will look at what would happen if the European economy were to shrink by 0.5% of GDP and if the stock market would decline by 15%. Any noticeable recession takes a couple percentage points off the economy, and the collapse of any large institution certainly would set off a chain of events
Second, the only major shock that the regulators are accepting is a reduction in stock markets. What about the bond markets? What about derivatives markets? These two dwarf anything that the stock market has to offer, and banks are major players. This thinking is far too optimistic.
Third, what about the linkages between other financial market participants and banks? It's a complex financial world out there, with cross-holdings and ownerships and investment positions across banks, insurance companies, unit trusts, hedge funds and other investment houses.
Fourth, everyone is wondering now what the terms of a bailout in Portugal will be, and what the consequences of a debt default in Greece would be. If those positions fail, then there will be major knock-on effects for the banks of countries throughout the EU. Refusing to stress test this is reckless endangerment of the European banking system.
Fifth, the banks still don't like it. Not surprising.
Finally, banks have been making announcements recently that they will raise new capital on markets to ensure that their vaults are sufficiently stocked to get a good review. But if they were doing the right thing in the first place, why would they need to? Banks don't like sitting on their cash. And raising new capital may mean borrowing briefly from other banks, only to pay it back once the inspectors are gone.
Stress testing in the EU has a long way to go before it does more than assuage public fears about banking solvency and liquidity. It needs more robust models and reporting between tests at a minimum.
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