As expected, the Committee of European Banking Supervisors (CEBS) released results of its much-discussed European bank stress tests Friday. And the results (drumroll, please)? A lot less stress than expected.
Before the release, most analysts believed that about 10 banks would fail the tests—7 actually did. The amount of capital needed in aggregate—€3.5 billion—was far lower than estimates ranging in the tens of billions. Even the seven banks failing were highly unsurprising. Five Spanish cajas (non-profit banks) failed. But it's no secret cajas are troubled—a government-created backstop already exists to aid them, with €88 billion still available. Germany's Hypo Real Estate and Greece's ATE Bank also failed, both of which were previously bailed out by their respective governments. (Perhaps an additional message here is government involvement isn't a magical panacea for banks? That seemed rather obvious to us well before the stress tests.)
But not everyone is overjoyed by the results. Similar to last year's US tests, many are critical of the criteria. Government-driven tests of risk lend themselves naturally to this—almost any "what-if" scenario used would be subject to doubt by someone. Friday, skeptics focused whether the bond value reductions (called haircuts) were big enough (particularly Greece's). Further, they complained the haircuts applied to just bonds a bank planned to trade, and not to those a bank planned to hold until maturity. But if you're not including a default scenario, then applying a discount to bonds banks plan to hold-to-maturity would be hard to understand using current accounting rules.
But some felt a Greek bond default should have been evaluated. Bank of France Governor Christian Noyer explained the CEBS' rationale, saying, "The hypothesis of a (sovereign) default is excluded because the European states, especially in the Eurozone, have put several hundreds of billions of euros on the table with the support of the IMF to make this hypothesis completely excluded." Maybe completely is a strong word, but excluding the combined (and massive) actions of the IMF, ECB, and EU from the analysis wouldn't make much sense either.
In the end, the European tests were actually more stringent and broader than their US counterparts a year ago—more of the banking system was tested with a less likely adverse scenario. And the EU banks fared better—but the comparison is a bit unfair since US tests were conducted in March and April 2009—during a recession and in the height of the volatility that accompanies a bear market bottom. Consider for a moment: in the US, the central issue degrading bank balance sheets before the tests was collateralized debt and derivatives marked down (due to wacky fair value accounting rules [FAS 157]) far more than any sovereign debt in Europe today. In addition, European banks were widely known to be carrying large reserves prior to the test. Put simply, banks are markedly stronger today than during the US tests.
While the tests themselves may not have revealed much new information, they do have some upside. Notably, they can increase confidence in Europe's banks easing access to capital markets. And a key positive is that they're over and done, and released for all to see. Markets tend to stress more about potential tests than actual results—uncertainties surrounding criteria, results, transparency, and effects, tend to worry markets more.
These tests aren't an "all-clear" sign for Financial stocks—headwinds aplenty still exist. But now that this chapter of the EU story is over, perhaps investors can focus more on other developments. And in other news, UK GDP almost doubled estimates, German business sentiment rose to a three-year high, and US corporate earnings growth (early in 2Q 2010's season) is averaging 34% with 78% of companies beating expectations[i]—underreported given Friday's big stress release.
[i] Source: Thomson Reuters
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