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Responding to the bank stress tests: Eurozone’s leadership – not the bankers - on trial

 

Executive Summary

The EU’s bank stress tests have proved one thing beyond all reasonable doubt: on the central scenario, the EU’s banks are in good shape. Even on the “adverse” scenario, the general problems appear quite manageable – until the rampant fears about sovereign defaults are factored in. This is no longer a banking crisis – it is blindingly obvious that there is a full-scale confidence crisis in the debts of some sovereign states who are also the implied guarantors of their banks. If the state is not in trouble, neither are the banks headquartered there. Conversely, if the banks are required to deal with the default of their government (often their largest debtor), then a downward spiral in economic activity is inevitable and imminent.

At the low point of the 1930’s US depression, Roosevelt said:” "the only thing we have to fear is fear itself". The Eurozone does not have to fall to such a low. At this vital moment, its leaders must show the same visionary capacity as Roosevelt: take a bold political step and grant massive, but conditional, loans that eliminate the risk of sovereign defaults for those states that have already had their economic policies scrutinised and agreed by the Eurogroup. Spirits will rise, yields will fall, banks can lend, consumers consume and industrialists invest.

Jump to: 7-point plan to restore confidence below

Background

The methodology for the stress test is based on the European Commission’s autumn 2010 Economic Forecast. The subsequent spring 2011 forecast is marginally more optimistic and certainly equity markets gained nearly 10% over the period – though slipping back again as the gravity of the public finance crisis sank in. The EBA’s chart (see below) sets the macro-economic scenarios in the historic context. The “adverse” GDP scenario specifies a decline that is slightly deeper than the 1993 recession – but stops well short of a re-run of the global financial crisis of 2007-10.

In the absence of a new blow – perhaps as a result of a crisis of confidence – the baseline scenario remains the more likely outcome. Indeed, the IMF has just raised its forecast slightly to be somewhat more ambitious than the Commission.

Looking to the future, the European Commission’s July 2011 Quarterly Report on the Euro Area lays out the very substantial adjustments that the eurozone members have already embarked upon (see its Graph 1.1). Expectations for such fiscal progress were underpinned when , at its July 12 meeting, the ECOFIN Council “…today adopted the country-specific recommendations to Member States under the first European Semester as endorsed by the European Council on 24 June. Member States will take them into account in their upcoming decisions, namely when planning their budgets for 2012.”

Taken together, these measures should see the aggregate deficit of the eurozone fall below 3% during 2012, with a continuing decline to around 1% in 2014. This will reflect the improved economic governance measures that are virtually agreed - and which are vitally important in making this profile credible and long-lasting (see earlier article). It must be enduring as the costs of an aging population will be felt keenly later in this decade.

This is not the fiscal profile of an economic “basket case”.In aggregate, the eurozone is exhibiting great strength but the challenge facing its political leaders is how to deploy this collective strength to support those members who are in the process of making very major adjustments.  If those supportive steps also underpin the achievement of the baseline scenario in the stress tests, then the picture for European banks is excellent – with a corresponding absence of the need for any significant additional government support.

The stress tests

Surprisingly, it is quite difficult to find the data for banks’ capital ratios under the baseline scenario as the EBA was so concerned – rightly - to be seen to have concentrated on the adverse outcome as this was the one which could precipitate grave economic problems. So the EBA’s main statement about the 2011 stress tests was:

• At the end of 2010, twenty banks would fall below the 5% Core Tier 1 Ratio (CT1R) threshold over the two-year horizon of the exercise. The overall shortfall would total EUR 26.8 bn.
• Between January and April 2011, a further net amount of some EUR 50 bn of capital was raised.
• Taking into account these capital raising actions implemented by end April 2011
• Eight banks fall below the capital threshold of 5% CT1R over the two-year time horizon, with an overall CT1 shortfall of EUR2.5 bn.
• Sixteen banks display a CT1R of between 5% and 6%.

However, buried in the massive tables is the following data: Aggregate CT1R in 2010 is 8.4% and this would rise under the baseline scenario to 9.4% in 2012 (versus falling to 7.1% under the adverse scenario). Bolstered by an annual flow of after-tax, retained earnings of nearly €60 bn, this ratio could be nearly double the minimum in 2013. This is not the place for a comparison of the EBA’s CT1 ratios and the Basel III definitions of capital, but the central message is that the EU’s banking system would probably have achieved Basel III 2018/9 standards many years early. Accordingly, Europe’s banking system would not be seen as at risk of a systemic crisis.

These tables also illuminate the “inter-connectedness” of the EU banking system and governments. The “gross direct long exposure” to sovereigns is €2,000 bn. There are some offsets via derivatives (but who is the counterparty to this?) though indirect exposures to entities subject to government guarantees are excluded. This amounts to approximately 20% of the “general government consolidated gross debt”. Assuming that the third of bank assets not covered in the stress tests are distributes similarly, banks may fund a quarters of public debts. Unsurprisingly, around 15% of the exposure has a residual maturity of 3 months. Thus any liquidity crisis for the banks would quickly feed through to governments.

Perhaps the eurozone’s leaders should stop spending their time on semantic debates about what constitutes an act of default and focus instead on ensuing that the baseline scenario occurs. The most likely cause of a deviation is allowing a massive blow to confidence that allows fear to grip the population. The collective eurozone economy and banking system is quite strong enough to resolve its undoubted problems – but it requires an act of political vision, and very soon. More dithering could precipitate a liquidity crisis for banks and weak governments alike that could well destroy the euro; the single market and even the European Union itself.

At the low point of the 1930’s US depression, Roosevelt said:” "the only thing we have to fear is fear itself". The Eurozone does not have to fall to such a low. At this vital moment, its leaders must show the same visionary capacity as Roosevelt: take a bold political step and grant massive, but conditional, loans that eliminate the risk of sovereign defaults for those states that have already had their economic policies scrutinised and agreed by the Eurogroup. Spirits will rise, yields will fall, banks can lend, consumers consume and industrialists invest.

 “Whatever it takes” surely includes the following – a 7-point plan:

Eurozone leaders keep saying they will do “whatever it takes” and they must now deliver on their commitments.

1. Agree immediately to the final element of Parliament’s proposal on the six-pack – enabling a courageous European Commission to propose prompt corrective measures to any State that is losing competitiveness due to unsound overall economic policies. The Member States could then only override such proposals by Qualified Majority Vote (QMV) – a tough requirement that would probably only be met in the event of manifest error by the Commission. These policies would underpin a strong probability of good economic behaviour into the foreseeable future.
2. Change the EFSF’s terms of reference to enable borrowing on demand by any State whose economic policies have been approved by the Eurogroup during the “European Semester”. However, that right to borrow would be subject to intrusive and regular checks to confirm that the State is maintaining its performance. If it is not, then any Eurozone state would continue to be able to veto further borrowings. Such exclusion would send a very powerful signal to markets that lenders were now at genuine risk and a substantial rise in solo borrowing costs would be the natural result.
3. Expand the size/remit of the EFSF to at least €1 trillion immediately:
   1. The EFSF is a mechanism that exists today; can be used immediately; is not a fiscal/transfer union and does not need tortuous Treaty changes.
   2. With a commitment to expand it as required by borrowers.
   3. Its remit should also be expanded to permit an aggressive programme of bond purchases as this might capture some useful profits for the European public purse. Correspondingly, those holders who sell to the EFSF would indeed take a major haircut from their private sector involvement (PSI).
   4. Perhaps it should be empowered to take over the ECB’s existing bond holdings so that any residual credit risk falls in the proper place – the Governments of the eurozone.
4. With such facilities in place, it would be difficult to argue that existing bonds could be in default – because they would be repaid in full on the due date!
5. The future borrowing costs of Greece (and other states at risk) would be reduced to levels that would make their debt burdens sustainable. (Doubtless their electors will still wish to pass judgement on the political class that created such burdens for the next couple of generations.)
6. With these guarantees in place, the ECB should have no qualms in continuing to accept Greek etc government bonds as “good” collateral. That would ease any liquidity problems of EU banks.
7. Confidence could revive rapidly as the daily media drumbeat of imminent disaster would vanish. Banks would not need to absorb investment capital against systemic risks that no longer exist and could boost lending to the economy instead. Declining long- term interest rates in many states would be a policy easing in itself.