The publication of the results of the stress tests on Friday, July 23rd is broadly up to expectations. The vast majority of the 91 EU banks, subject to the exercise, passed successfully their examination, which should reassure markets. One should therefore commend the initiative of the European Council to have followed the example of the United States and also to have promoted transparency by publishing not only the test results but also the methodology on which they were based.
The aim was to restore confidence of the consumer in financial markets and in “their banks” as well as trust between banks themselves at a point when, after a slow improvement of the interbank market, the latter was showing once again signs of deterioration. The impact of the tests on the interbank market will probably turn out to be one of the most reliable indicators of the success of the whole operation. The evolution of the interventions by Central Banks, and by the ECB in particular, will be closely scrutinised so as to establish whether there is any need to maintain the banking system in intensive care by providing the necessary liquidity for its smooth operation. Should this prove to be the case, the reliability of the tests could be brought into question.
Why is there then such a polemic surrounding the credibility of the stress tests? For two reasons:
The first results from the poor reputation the authorities in the aftermath of the crisis due to their incapacity of preventing it in the first place and the difficulties they continue to face in the implementation of the necessary reforms. Even in the United States, where the most sweeping financial reform since the 1930s has just been enacted, the proposed rules remain well short of expectations, in particular through the significant watering down of the “Volker Rule” aimed at protecting depositors and taxpayers from proprietary trading risks by banks having access to the Fed window. Within this context, the communication conducted by the authorities prior to the tests aroused fears that they would manipulate the results as a function of a dual objective: allow a sufficient number of failures to ensure credibility but not too many to worry markets. The results conform to this scenario and are liable to raise doubts among sceptics.
The second reason is far more fundamental and relates to a flaw in the methodology concerning the third scenario covering the resistance of banks to their “sovereign risk” exposures. It arises because of the inherent difficulties deriving from the opposition between the “intergovernmental” approach that prevails at Union level and the partially “supra-national” reality in place within the Eurozone, in particular the aspects covering the pooling of sovereignty with regard to the currency and monetary policy (but neither regulation or supervision). The tests having been decided at EU level, it is the former approach that has prevailed, inducing important consequences.
Indeed, the status of sovereign debt held by banks is fundamentally different, depending on whether the country in which it is located has – or not – retained full sovereignty over its currency. Only the 11(soon 10) EU Member States, that do not participate in EMU, retain this sovereignty.
For the 16 countries who have adopted the euro, their “sovereign debt” has many more of the characteristics of private debt, that is to say an enhanced capability of default (comparable to the debt of individual States in the U.S.A). It behoves examiners to apply to the evaluation of the risks implied, the same criteria of diversification, reserve requirements (haircuts) etc., as those applicable to other banking assets. For the 11 remaining Member States, who retain the option of paying off their debts by having recourse to monetary creation but at the expense of a costly inflation it is acceptable to have less constraining requirements.
It was, indeed, impossible, for evident political reasons, to differentiate between the treatment of sovereign debt of EMU Members and non-members. It is this constraint, which was largely ignored - or even deliberately hidden by those who understood the matter – that is the root cause of the debate concerning the methodology of the stress tests. One can readily understand this reticence when one takes into consideration the extent to which EMU Members are tributary to their banks for the placement of their debt. This was particularly the case at the time when most States were forced to significantly increase their issuance to rescue failing financial institutions or to finance desperately needed stimulus plans. This also explains the benign approach of regulators in their evaluation of risks associated with holding sovereign debt and the generosity of the ECB in setting the criteria for eligibility of sovereign debt instruments as acceptable collateral.
The market is far from being unaware of this situation, so that authorities should hardly be surprised if, periodically, attacks have been - or are in the future - mounted against the debt (and against the banks who hold it) of EMU members, even though the global financial situation of the Eurozone (level of indebtedness to GDP – average budgetary deficits) appears far less dire than, for instance, that of the United States or the United Kingdom. These attacks do not necessarily have a purely speculative purpose, (an argument frequently put forward by the authorities) but result, more often than not, from soundly based prudential risk management principles applied by investors (including banks) which are worried about the capabilities and associated costs of refinancing the debt of EMU Members and therefore of the risk of default.
Clarifying in this way the current state of affairs leads to another question which is directly related to the former: how can EMU Members regain the prerogatives of monetary sovereignty so they benefit from a level playing field with other Sovereign States?
The first and apparently most straight forward answer is an “exit” from EMU. Fortunately, this approach has been rejected out of hand as totally impracticable as it creates far more significant problems than those it is aimed at solving. Indeed, short of suspending debt servicing or repudiating in part its debt, the outstanding “sovereign debt” of the exiting Member State will remain denominated in euros (as a result of the principle of continuation of contracts). Furthermore, it is difficult to conceive how a bank whose liabilities will remain expressed in euros can weather an exit from the single currency while on the asset side many of its debtors will be made insolvent.
This alternative being excluded, it becomes unavoidable to seek ways to reinforce EMU solidarity as well as the credibility of the single currency, the basis for which has been so well managed by the ECB during its first ten years of existence. Two options are possible which are not mutually exclusive but, on the contrary, highly complementary.
The first, to which the EU is already strongly committed under the leadership of President Van Rompuy with the full support of the Council, aims at significantly reinforcing the Stability and Growth Pact. This is another way of describing the emergence of a truly EMU level financial and economic “governance” (rather than government). Its credibility remains to be established, mainly through its capacity to impose compliance with its rules and, if necessary, its ability to sanction offenders.
The second, for which the setting up of the “European Stabilisation Mechanism of the Euro” by EMU Members constitutes the embryo, aims at creating a fully fledged “sovereign debt” instrument as part of a stable financial mechanism readily accessible to EMU participants. Over time, this mechanism will have to benefit from the joint and several guarantees of EMU Members in order to establish its credibility. In this manner, both a borrowing capability and a monetary creation capability will have been created covering identical geographical territories, conferring to the debt issued largely similar characteristics to that of other sovereign States. It is therefore of the utmost importance that the commendable efforts already accomplished be pursued and strengthened because the system as currently envisaged can only be considered and transitory: indeed its current duration and structure cannot be considered adequate to allay solvency concerns of investors over time.
In conclusion, to the extent that the stress tests will have contributed, in addition to restoring confidence in the EU banking system, to stimulate the necessary deepening of economic and financial integration of the Union, then they will have made a decisive contribution to the stabilisation of financial markets and the establishment of a solid base on which to build future growth.
Brussels, 26th July 2010
Paul N. Goldschmidt
Director, European Commission (ret); Member of the Thomas More Institute.
© Paul Goldschmidt
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