ECB Stress Tests are 'Dead on Arrival' as Deflation Grips

Published: 16th October 2014 12:04 AM  |   Last Updated: 16th October 2014 12:04 AM   |  A+A-

It's the banking fix which is meant to set Europe on the path to economic recovery. Regrettably, it promises to be just another damp squib. Too little, too late and too backward looking, it may already have become largely irrelevant for a Continent which seems fast to be slipping into deflation.

For much of the past year, the EU's 130 largest banks, together accounting for 85pc of European banking assets, have been conducting an exhaustive process of "stress testing" their balance sheets against a series of supposedly worst case economic calamities. One bank, I'm told, has devoted 20pc of its staff to the tests, leaving everything else to go to hell in a handcart.

The purpose of the exercise is to identify which banks do not have sufficient capital to meet the imagined shocks, and then require them to recapitalise accordingly, thus restoring confidence in a banking system that, as things stand, nobody trusts.

The results are due to be published on October 26, triggering further capital-raising which, according to some City estimates, could amount to euros 50bn or more. This is in addition to the euros 70bn already raised so far this year in anticipation.

Once complete, then credit growth can begin anew and economic recovery will follow seamlessly in its wake. That, at least, is the hope; as ever with Europe, it seems to be built largely on sand.

There have been two previous attempts to stress test Europe's banks. The first was so deficient that it famously found the Irish banking system to be perfectly solvent. Since then, a sum roughly equivalent to half a year's national GDP has been spent on Irish bail-outs. The second wasn't much better, so there is a lot riding on the third attempt, particularly as it marks the ECB's official appointment as overarching supervisor for the eurozone banking system.

The birth of a "single supervisory mechanism" for Europe is, by the way, in itself proving a mind numbingly complicated process, involving multiple layers of duplication, instruction and general regulatory grief. If there is still a banking sector left at all by the time the bureaucrats have had their fill, it will be a minor miracle.

There will be 69 individual "supervisors" looking after Deutsche Bank alone, with the lead regulator a French national to avoid any suspicion of national favouritism. Likewise, the lead supervisor for BNP Paribas will be Spanish. It would be amusing to think the Greek banking system will be assigned a German but that might be thought an insensitivity too far.

Depending on who you talk to, the separate stress tests being conducted on British banks by the Bank of England are said to be much tougher. True or not, HSBC for one finds itself stress tested once in the UK for the bank as a whole and a second time for qualifying subsidiaries in the eurozone. Small wonder there is no credit growth going on with this kind of nonsense to deal with.

On the plus side, the tests are being applied to balance sheets as they existed at the end of last year. Since then, many banks have taken steps to raise more capital and/or further reduce the size of balance sheets.

Perversely, the process of stress testing may therefore have exacerbated the problem of credit contraction. Still, at least the capital shortfalls will now be smaller than they were.

On the negative side, the capital raising has so far been confined largely to the more solvent banks. The real problem banks in Germany, Italy, Austria, Greece and Spain have yet to be dealt with. Unlike America, where banks that failed US stress tests had government capital forced on them, it is not yet certain where the money is going to come from.

For some eurozone countries, further bail-outs may stretch already deeply impaired public balance sheets close to breaking point.

Yet these are comparatively minor concerns set against the big worry about the eurozone stress tests - that they simply miss the point. They are admittedly somewhat tougher than their forebears. But they also focus to a large extent on the wrong thing.

In doing so, they have become the banking equivalent of the Maginot Line, the chain of concrete fortresses erected by the French in the 1930s to defend the border from German invasion. Regrettably, when the Germans came, it was from a different direction.
Similarly, by focusing strongly on the possibility of another sovereign bond market shock, banking supervisors are looking in the wrong direction. On one level, this is understandable.

That's where the shock came from last time, when growing fears about sovereign solvency produced a so-called negative feedback loop, where plunging bond prices undermine the solvency of the banking system, which in turn further calls into question the solvency of the sovereign.
Today, this is the least of the eurozone's problems.

Rather, it has changed to one of nascent deflation. If it became established, deflation would of course wreak its own havoc on debt dynamics, for increasing the burden of debt is one of deflation's most deadly side effects, and one of the biggest reasons why you really don't want to catch the disease.
Even so, this is not a scenario that the stress tests address in any serious fashion. Indeed, their adverse scenario for inflation, set way back when, is 1.1pc for this year. In fact inflation is already less than half that and is still falling. The eurozone is also already some of the way there to meeting the adverse scenario for growth.

Even if well directed, the stress tests cannot in any case deal with the deep structural barriers that exist in Europe to resumed credit growth. Some countries are better than others but in Italy insolvencies take six to seven years to wend their way through the semi-corrupt legal system. In Greece it is an astonishing 10 to 15 years. Hard numbers are difficult to establish but Europe's banking system is shot through with non performing loans, many of which will not be recognised by the stress tests.

In most countries, the procedures for fast track debt restructuring simply don't exist, nor is there any private equity industry to assist with debt for equity swaps, corporate restructurings and salvage. Finally, there aren't the well developed capital markets to fill the hole left by the paralysed banking sector.

Europe still has a mountain to climb in even recognising these deficiencies, let alone doing anything substantive about them. Sorry to rain on the ECB's stress test parade but, in itself, it is most unlikely to lift the gloom.


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