Reviewing the bank stress tests – July 2011

As was seen during the stress tests carried out in July 2010, the latest ones published by the European Banking Authority on the 15th of July 2011 do not include a proper measure of market systemic risk. This hinders their credibility.

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About a year ago, on the 23rd of July 2010, stress test results were being expected for 91 banks present in the Euro Zone. The aim of those tests was to assess whether those banks would meet liquidity requirements in supposedly very adverse scenarios. Faced with a string of unfavourable hypothetical conditions, the banking institutions needed to show that they could retain a solvability ratio above 6%. Under Basel 3 regulation, this minimum requirement will be lifted to 7.5%. The latter would correspond to a minimum core capital ratio of 4.5% and a security cushion requiring an additional 2.5% meant to absorb losses in highly adverse economic conditions.

The results were quite reassuring in the sense that only 7 banks out of the 91 tested failed to meet the standards set (Among those were 5 Spanish savings’ banks, 1 German Landesbank and 1 Greek bank). We now know that these tests were worth nothing since their credibility was shattered 4 months later when the Irish banks started failing. Following the spread of the European sovereign debt crisis, an 85 billion euro bailout plan was executed for Ireland during November 2010 out of which 35 billion were aimed at recapitalising Irish banks despite the fact that the latter had been successful at the tests. Within this amount, 10 billion were immediately put to use to ensure the banks’ survival while the remaining 25 billion were set aside as emergency funds. These reserves were quickly drawn down when in March 2011, the 4 main Irish banks (Allied Irish Bank, Bank of Ireland, EBS and Irish Life) required an additional 24 billion euro recapitalisation effort. Tailor made stress tests (those of July 2010 having shown their ineptitude) would later indicate

We all know that the banking stress tests could not display catastrophic results because we would have then entered a negative self fulfilling spiral
Mory Doré

If the markets are convinced that the banking system is not properly capitalized and more importantly if they feel that the strongest states, the IMF, the European Union and the emergency funds which were recently created prove unable to act quickly and decisively in providing liquidity to the banks, then we run the risk of facing a vicious circle. The latter would start with banks being unable to lend to the economy and invest in financial markets due to insufficient capital. This would lead them to an unstable situation in terms of resources (bank run risk, interbank market paralysis and the incapacity to issue on the bond market) which would consequently lead to a collapse of the real economy and in the value of all categories of financial assets (with the exception on the most secure sovereign bonds and to a lesser extent safeguarded securities such covered bonds and land secured bonds). Further provisions would then have to be included in the banks’ accounts causing further dwindling of capital and consequently new threats on the solvability of banks.

The whole point then is to find the right equilibrium when carrying out this exercise. Credibility is key and this implies being transparent while reassuring the markets on the measures which will be applied. The least that can be said is that this new exercise (carried out during the month of July) does not tend towards this equilibrium.


The European Banking Authority has announced on Friday the 15th of July that it will publish the results of the new banking stress tests. These tests will once again cover 91 banks holding 65% of the European banking assets. Spain is the most highly represented country with 25 banks followed by Germany (13) and Greece (6). 2 scenarios have been elaborated, the first one being a base case scenario built around the main current macroeconomic forecasts and the second one being focussed on hypothetical deteriorations of the economy. This would include a 1.5% European GDP contraction in 2011, a 15% collapse of European bourses and real estate markets and an increase in the cost of interbank refinancing. No sovereign default is however considered.

The results are quite encouraging since the European Banking Authority has indicated that only 8 banks had failed the tests imposed to the 91 European Banks (Failing equalled displaying a core tier one ratio lower than the 5% targeted) . The failing institutions which consisted of 5 Spanish banks, 2 Greek banks and 1 Austrian bank needed only 2.5 billion euros to reinforce their solvability. Let us remind that 16 banks which include 7 Spanish banks have narrowly passed the tests since their core Tier one ratio is within a 5% - 6% range.

This looks very surprising considering the fact that recapitalizing efforts needed to be quite significant back in 2010 when market conditions were somehow pacified. This is illustrated by the Irish aid programme but also the Portuguese 78 billion euro support package which included a 12 billion aid to Portuguese banks. This does not include state guarantees aimed at facilitating bond issues on medium term maturities by several banks which would be unable to do so without them.

First of all, we did not include the possibility of a full blown liquidity crisis similar to that of September 2008 and also the risk of a sovereign default was not considered
Mory Doré

The results prove to be satisfactory because the systemic risk has been voluntarily left out. This creates a dilemma. If this type of risk is seriously considered, a counterproductive self fulfilling prophecy will take place whereas if it is not, credibility will suffer and trust will not be safeguarded. This is likely to happen during the next two weeks.

Applying more credible stress tests therefore implies that the systemic dimension of market crises is taken into account and that strong political and institutional answers are associated to them. These will help in preventing any self fulfilling prophecy from happening (we are currently working on a paper dealing with this phenomenon which came back to prominence regarding the behaviour of rating agencies).


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This brings us back to considering two types of recent systemic events in the history of financial markets. They are banking systemic risk leading to a general liquidity crisis and sovereign systemic risk with its consequences on portfolio provisioning for banks and insurance companies.

First of all, no one imagined a liquidity crisis that could compare itself to that of September 2008. We can remember how it paralysed the whole interbank market and how central banks had to fill in for the markets by injecting unlimited amounts of liquidity. The stress tests have indeed indirectly taken into consideration liquidity risk with hypotheses of rising liquidity costs. However, if liquidity has been stressed pricewise, it has not been the case in terms of volume. It is on this last element that a bank’s resistance can be truly tested. The same can be said of banks which have carried out the efforts to set up mechanisms allowing their liquidity to be assessed both quantitatively and qualitatively in extreme market conditions that would negatively impact their balance sheet. It is therefore necessary to assess a number of elements such as:

-Reserves of highly liquid securities which are secured or very well rated belonging to the bank as well as the ability of these securities to be easily traded even in adverse market conditions.

-The bank’s refinancing capacity on the markets or when seeking a central bank which requires being able to assess the value of immediately usable collateral (IOUs eligible to ECB tenders ; mortgage debts and community debts that can be backed against secured bond issues)

-Stability in immediately accessible resources and long term savings on the balance sheet that has been collected from clients. (Credible stress situations imply that inert credit flow is met with resource depletion in the balance sheet as well as a slight bank run)

If liquidity has indeed been “stressed” pricewise, it has not been the case in terms of volume. This latter dimension is however the true criteria on which a bank’s resistance can be truly tested
Mory Doré

Secondly, with those stress scenarios the other major systemic element consisting of a sovereign default has not been included due to liquidity and / or solvability crisis reasons. Only sovereign portfolios that are part of trading books and which have subsequently a direct impact on results have been included. However, these portfolios only represent a small share (15% - 20%) of sovereign debts held by banks. Positions which have not been classified under trading activities but under what is labelled as the banking book (80% - 85% of state loans held) will, under IFRS rules, find themselves within the AFS accounting category and labelled as “available for sale” and HTM (Hold to maturity). Compared to fair value or trading classification, falls in portfolio value will not directly impact results even when these falls happen to be significant

It happens that a default or what could be described as a credit event (several interpretations can carried out on this term) on a “fragile” euro zone country would most likely force a banking institution to relegate sovereign securities as bad debts including those in the banking book. In that case, all the positions held on this issuer would negatively impact the net result due to the increase in provisions for long lasting depreciations. It should therefore no longer be taboo to stress this type of scenario especially since we know that a partial default of Greece has become inevitable by the end of 2011 and that other debt restructuring measures will most likely need to be taken in peripheral countries (what is the limit of that periphery?) in 2012- 2013.

Mory Doré July 2011

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