Take the stress out of stress testing

By Diana Ouamar, risk consultant, Rule Financial Since the start of the year, it has been made clear that European governments are likely to face fresh attacks about the state of their economies throughout 2011 and beyond. The UK’s chancellor of the exchequer followed the New Year festivities with a stark warning to European finance …

February 2, 2011 | Rule Financial Ltd.

By Diana Ouamar,
risk consultant,
Rule Financial

Since the start of the year, it has been made clear that European governments are likely to face fresh attacks about the state of their economies throughout 2011 and beyond. The UK’s chancellor of the exchequer followed the New Year festivities with a stark warning to European finance ministers in a comment piece for the Financial Times. He warned that they “must put [their] own house in order” (1.) if the European Union (EU) is to remain a powerful international player. In a meeting with European politicians and economists in Paris, George Osborne cautioned European countries that they could become “bystanders” to a sustained worldwide recovery if market concerns of sovereign debt levels and the reforming of weak European banks are not adequately addressed.

Mr Osborne also remarked that stress tests performed in July 2010, under the guidelines and oversight of the Committee of European Banking Supervisors (CEBS), “were not good enough” and he reiterated the case for more frequent and intense stress testing of these financial institutions.

This subject has been under great scrutiny of late following the recent bailouts of Greece and Ireland, which raised serious concerns over the effectiveness of earlier stress tests. More specifically, it provoked real unease, since all of the major Irish banks passed the CEBS stress tests in the summer of 2010, yet less than six months later, worries over the financial stability of those same Irish banks were cited as “a” (if not “the”) primary reason that a bailout had to be mobilised for the whole of the Irish economy.

As a result, investors still feel extremely anxious about the health of many of Europe’s financial institutions, and fear governments will have to incur more bailout costs. It therefore comes as little surprise that the EU has announced that it will conduct a second round of stress tests for banks in spring 2011.

The July 2010 stress tests were not, however, completely redundant as they acted as a good benchmark for peer comparison by broadly assessing the health of Europe’s banks, as well as demonstrating that in general the European banking system is well capitalised. However, the tests were not enough to deliver full confidence in the markets; indeed stress-testing 91 banks from 20 different countries can never be a “one-size-fits-all” exercise, given the differences in size, complexity, business models, scope of operations and risk profiles of the banks in question.

More importantly (aside from the ‘one size fits all’ approach), the July 2010 stress tests were heavily criticised for being too lenient and neglecting to take into account some additional key risks. For example, during the credit crunch, ‘crisis solvency’ and ‘liquidity risk’ had critical implications for the entire global banking system, yet surprisingly these elements were not mentioned throughout the stress-testing exercise.

Having been modelled on the May 2009 stress tests conducted in the US on 19 American banks, the July 2010 round of checks on European banks has also left many unanswered questions and issues. Firstly, Tier 1 capital still includes hybrid capital items that were not loss-absorbing during the last financial crisis. Many have asked why the CEBS did not use the Core Tier 1? There have also been doubts about using a Tier 1 ratio of six per cent instead of a more robust seven per cent. It is very unlikely that only seven banks would have failed the July 2010 stress tests had the ratio been set at this higher level.

The scenario of a well capitalised bank that is also illiquid during a downturn was not accounted for during the July 2010 tests. Nor was the amount of transparency provided by individual banks and the capital measures they have in place. Another important consideration that was neglected was how the CEBS assessed sovereign risk. Currently, where sovereign debts are concerned, only the trading book has been assessed, not the banking book. Only around ten per cent of sovereign debt (such as Greek government bonds) is held in a typical bank trading book, while around 90 per cent is held in their banking book. What would happen if a European country defaulted on its debt? Take, for example, an unthinkable, but possible Spanish debt default.

It is obvious that the new stress tests need to be much more rigorous, more comprehensive, and based on a revised financial architecture. Crucially, the new stress tests need to take into account all of the key risks, including important risks such as solvency and liquidity that were previously omitted. In addition, a sovereign default scenario in a stress test should be one of the key elements in addressing today’s concerns and pessimism surrounding European banks. Currently, European banks hold billions of dollars of various governments’ debt, but they are also confident that their own government will be their lender of last resort in times of crisis. Finally, in regards to the capital requirement, the CEBS needs to take into account elements of Basel III relating to the new definition of core Tier 1 and Tier 1 capital. Once all these factors have been included, the CEBS can demonstrate to the world that lessons have been learned and the new stress tests are highly robust.

It is clear the EU is experiencing a period of intense ‘euro scepticism’. The situation has swung from a banking crisis to a sovereign debt crisis. With Basel III, it seems that politicians have been the principal decision-makers, while regulators try to design a framework to match political expectations. In relation to the stress tests, it is time for European regulators to independently make the right decisions without fear of any political impact.

If this new round of stress testing is conducted properly and addresses all the risks, it will help to reduce the reputational risks for core European countries and avoid an increase in their borrowing costs. It will also help alleviate pressure from other countries such as the UK, and perhaps prevent similar caveats like that of Osborne’s to carry out such checks on a tougher and more regular basis. Ultimately, the impending stress tests need to be accomplished in the best way possible if the European banking system is to restore investor confidence and the market is to return to a period of stability for many years to come.

1. Europe must start putting its house in order – George Osborne comment piece – FT (published on January 5th 2011)

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