07 December 2011

Onado/Resti: EBA and the capital of European banks - don’t shoot the messenger

The newborn European Banking Authority has been fiercely criticised in the few months of its life. This column argues that most of the criticisms have been driven by lobbying interests more than by noble worries on the future of the European economy.

According to many observers:

• this summer’s stress tests were ineffective; and
• the October rise in capital ratios to 9 per cent has raised concerns about a massive credit crunch.

The authors, Marco Onado and Andrea Resti, think these criticisms are off the mark. As happens to regulators, analysts are in the process of shooting the messenger because they don’t like the message.

Criticism 1: The July stress tests were “inherently flawed”

Many analysts judged the July stress tests too mild, mainly because they did not explicitly factor in a default of Greek sovereign debt. But this misses the point. The EBA stress tests were a great step forward from the point of view of disclosure. For the first time, markets could see full information on each bank’s exposures, by country, debtor type, and maturity. Moreover, funding costs of individual institutions were disclosed, both historical and in the adverse scenario.

Criticism 2: EBA’s stress tests have been less effective than the tests conducted by the Fed in 2009

There is no doubt that, unlike the US exercise, European stress tests failed to reassure the markets, Here critics seem to have a point. A comparison of the European stress tests to the 2009 US exercise (Supervisory Assessment Capital Program) provides an explanation. The US administration wholeheartedly stood behind the stress-test results, mandating undercapitalised banks to quickly raise extra funds and providing those funds when needed and assuring the market that public capital would have been available in case of need. European governments did not reach an agreement on this point and could not give any precise commitment. Even worse, they still appear bent on the same mistakes.

Criticism 3: EBA capital increase creates a credit crunch

The argument can be reversed. Again the problem is the freezing of the European bond market that has already significantly impaired the funding ability and triggered a credit crunch.

Criticism 4: The EBA’s request for a new round of capitalisation is “absurd” and must be dropped

This position does not take into account that European banks have a lower level of capital than their competitors in the US. Based on 2010 data, the top six US banks had an average Tier 1 ratio of 13.2 per cent, compared to 12.1 per cent for their EU counterparts; if one looks at Europe’s top twelve banks (as it may be appropriate to account for Europe’s higher fragmentation), that would further drop to 11.4 per cent. In terms of leverage, the difference is even more striking. Some big European banks have a capital base which is a meagre 2 or 3 per cent of their total assets.

Conclusion

The current market turmoil (sometimes described as an unwanted consequence of the euro) must be addressed by stronger European integration, not by a return to national selfishness. A pan-European guarantee scheme for banks, a ’big bazooka’ for sovereign debt which does not boil down to a pop gun, stronger bank supervision at the EBA level– these are the steps to be taken, if only someone in Berlin and Paris could move.

Most of the criticisms to the EBA request have been driven by lobbying interests more than by noble worries on the future of the European economy. As Robert Jenkins (2011), now member of the Financial Policy Committee of the Bank of England recently stated: “The banking lobby has responded by blaming Basel. […] In short the latest lobby tactic is to convince pundits, public and politicians that encouraging prudence too soon will hit the economy too hard. This is no longer amusing. This strategy is intellectually dishonest and potentially damaging”.

Full article

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