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Sense on Cents Enters The Debate Room

Posted by Larry Doyle on June 17, 2010 2:24 PM |

Should European banks conduct bank stress tests. Should individual bank’s test results be publicized? Should the results in totality be publicized? Can the tests themselves be fairly administered and generate robust results?

Bloomberg Businessweek recently asked for my thoughts on this topic for purposes of generating a debate. The Debate Room was just published:

PRO: A SURVIVAL MECHANISM
by Bill Bartmann, Bartmann Enterprises

It makes good sense for Europe to conduct a series of stress tests on its banks so that countries and companies have some better sense of their risk exposure.

Financial institutions use stress tests to determine the degree to which a bank or financial institution can withstand a shock of a given magnitude. For example, instead of doing a projection on a best-estimate basis, the bank does a scenario analysis looking at negative variables: What happens if interest rates rise to X percent? What happens if loan defaults rise to X percent? What happens if gasoline prices rise to $X?

But stress testing has relevance for other entities as well. One can apply stress tests to an entire nation. For example, what is the impact on the U.K. if the euro falls 25 percent? Or what happens to Germany if Greece defaults on its national debt? Stress testing also works with nonbank companies—say, a manufacturer or a retailer: What happens to Nestlé (NESN:VX) if the dollar rises and exports to the U.S. become more expensive?

The G-20 Financial Stability Board is urging European nations to publish the stress-testing results of its banks, and cites the openness of stress testing in the U.S. as a factor beneficial to restoring market confidence. Conservative or progressive, we can all agree that more stability in markets is a very good thing.

CON: FAULTY MECHANICS
by Larry Doyle, Sense on Cents

Given the success of the bank stress tests run here in the U.S., should the same tests be administered in Europe as a precursor to economic recovery? Only if you believe in shell games, manipulating vigorous accounting principles, and the concept of “too big to fail.” Aside from that, I believe our bank stress tests were largely a charade, and the same would likely transpire in Europe.

For any financial test to be deemed credible, the test itself needs to be truly robust. Those in America may claim our bank stress tests were truly successful, but I firmly believe the tests should be graded incomplete at best.

Why do I make this claim? Let’s enter the world of HELOCs (home equity lines of credit). The base-case assumption used in our bank stress tests was for cumulative losses on this product of 6 percent to 8 percent with a worst-case scenario of 8 percent to 11 percent. Those assumptions were ridiculously low. Our banking system continues to be chock-full of likely hundreds of billions in losses on this product. Those losses were largely overlooked in our tests.

Would European bank stress tests fully expose the nature and value of a variety of loans held on their books or merely disguise them in the same manner as the U.S. tests? If European governments want to play that game, then they should go right ahead and run the same tests and play the same charade, but do not expect real transparency and integrity along with them.

What do you think? How do you score it? Please leave your thoughts and comments at the Bloomberg Businessweek site, as well. Thanks!!

LD

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  • Mike

    The man above you brings up some excellent points about the positive effects of a well conducted stress test. However, he fails to mention anything about the integrity or parameters of the actual test which is to be conducted. He isn’t wrong but sort of misses the point.

    I think you are arguing two different topics.

  • Sweet Ebony Diamond

    Hello Larry,

    I like your points.

    The pretend and extend policy is going to have a bad ending.

    S.E.D.

  • coe

    LD – There is no doubt in my mind that the stress tests in the US provided some optical comfort, but that the assumptions that drove the numbers were flawed and didn’t capture the risks with anything remotely approaching “market” accuracy..I’m also of the distinct (and validated)impression that individual banks “worked” the numbers with the regulators as the tests were conducted – a little bit like a college student helping his professor grade his own essay..that said, if the formulaic approach was reasonably CONSISTENT across all banks, then we would get valid RELATIVE results..Is anyone surprised that part of the objective was to use these soft forensics to engender confidence in the banks and financial system at a time when more bad news could have proved to be the tipping point? I expect the same from the exercise in Spain and presumably the Euro zone as a whole..you speak to the implications in your column on investing in China – questionable accounting combined with regulatory policy intrusion/inconsistencies/ and politics equal valuation uncertainty for investors..the plain unvarnished truth is that virtually all banks have material unrecognized “mark-to-market” exposures that they are dancing around..if asymmetrically in an accounting sense (i.e. asset transparency with no corresponding offset for liability duration) a gun was put to the head of the global banks and they actually marked these assets to current liquidation pricing, the capital accounts, already in precarious shape, would be woefully short of regulatory requirements – oh, but then select big banks could pull out their “get out of jail free” too-big-to-fail free pass, while many regional and community banks would find police tape around their buildings on any given Friday and swell the footings of the FDIC resolution tables..there is no real debate – kabuki theater is an acquired taste and not for everyone..as Harrison Ford, playing everyman hero Jack Ryan said when asked by the President to do the ‘ol Potomac two-step in “Clear and Present Danger”, he responded “I’m sorry Mr. President, I don’t dance” – a mark to market moment in cinema! Well, if we are not facing “clear and present danger” now on many of these fronts we never will be… avoid the two-step, LD, and, never ever consider doing the lambada with the policymakers!

  • divvytrader

    stress tests a complete fraud ….. sovereign debt will be treated the same as US Treasuries ( say what ? its plunging sovereign debt that is the heart of the matter ) .

    Thus we see the whole scam suggestewd by Turbo Timmy Taxcheat is to make it look like a big deal while in reality it will be a complete whitewash based on fake assumption sovereign debt gheld at banks is 100% safe / UST equivalent ….. all in a failing effort of course to try and convince the world its safe to buy EU debt again before the ECB runs out of buying power ….

    From Morgan Stanley today :

    Will stress tests include haircuts on peripheral Sovereign debt?

    Our take: The guidance we have been given is the tests were not going to include any discussion of sovereign risks for all sorts of obvious reasons, not least the massive EU/IMF support plan for Greece and back-up for other countries. We think that some investors will be disappointed by this. To be clear, one does not have to have a strong view on the outcome of the peripheral bonds either way to realize that a bank with a large concentration of Greek bonds as % of tangible equity may act in a far more risk averse fashion in extending credit than one with a much lower %, given the uncertainty on how this will play out over the coming years – see the exhibit below. This surely is an issue which macro-prudential policy should weigh up, independent of taking a view on what will happen on the debt itself. As we argued in our last note, the vast majority of banks which hold Greek bonds in their held to maturity books have not sold their Greek debt. However, it appears that this is a keen debating point. Madame Lagarde told Reuters today: “We will stress the system a little more to make the results more credible.”

  • divvytrader

    Architect Ben: Lets give this bridge a stress test.

    Engineer Tim: OK, how.

    Architect Ben: Lets run a hamster over it.

    Engineer Tim: OK.

    Both: Wow, the bridge held up. Tell the media to report to the people that all is well.

    • Steve

      …the bridge may have held up but now the toll being paid by American taxpayers instead of the bank creditors is huge and will be in place for a LONG time.

  • Steve, in relation to the US tax payers picking up the toll, I would ask, which country cause the banking crisis?






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