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Will European Bank Stress Tests Be “Garbage In, Garbage Out?”

Posted by Larry Doyle on July 23, 2010 6:52 AM |

All eyes will turn toward Europe this afternoon for the much anticipated release of the Euro-style Bank Stress Tests. Those who truly embrace real ‘sense on cents’ know that the process and the data are far more important than the actual results. Why is that? If these tests are charades or nothing more than ‘garbage in,’ then the results will most assuredly be ‘garbage out.’

On this note, let’s review a few comments from a Bloomberg preview of these tests. Bloomberg reports, Success for Stress Tests Hinges on Data, Not Failures:

1. The success of the European Union’s bank stress tests hinges on how much detail regulators provide about the basis for their conclusions, not on the number of lenders that fail, investors said.

“The more transparency, the more important that the results will be,” said Peter Braendle, who helps manage $51 billion at Swisscanto Asset Management in Zurich. “If the methodology is a black box and we just get some results, that will not be very helpful.”

2. “It’s pretty clear that a lot of banks will pass this test,” said Lutz Roehmeyer, who helps manage about $15 billion at Landesbank Berlin Investment, including bank shares. “It will be more important to see what raw data will be published. With that you can create your own, more stringent scenarios.”

3. Investors have criticized the tests, saying they may not be rigorous enough. In particular, they are questioning to what extent regulators are examining banks’ sovereign-debt holdings, including how government bonds in the trading and banking books will be valued in the event of a sovereign debt crisis.

The tests won’t include the possibility of sovereign defaults, Dutch Finance Minister Jan Kees de Jager said last week, indicating that there will be no assumed losses on government bonds held in lenders’ banking books.

Rigorous enough? How interesting. Are rigorous and robust synonymous? Common ‘sense on cents’ would dictate they are. I raised the very question of how robust the tests will be in my assessment of the tests last month in a Bloomberg Businessweek debate. Let’s rewind and review from Sense on Cents Enters the Debate Room;

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!!

Let’s reconvene this afternoon and make our assessment of just how rigorous and robust the tests truly were.

LD

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  • Sweet Ebony Diamond

    Whatever information the banks release to the regulators will be garbage. Even it is audited.

    The only objective report on the state of a bank that I have ever read is Valukas’ report on Lehman Brothers.

  • fred

    Once again, it all comes down to “mark to market” or “mark to model”. As in the US, fabricated pricing using “mark to model” criteria are being used.

    US banks used “mark to model” because they said they were going to hold securities to maturity; where are most of these securities now, on the Feds balance sheet, they weren’t held to maturity.

    • fred

      Why don’t teachers give the answers to students before an exam…When the Dutch Finance Minister came out and stated that the possibilty of sovereign debt default wouldn’t be considered if held in the banking book, why would any bank post it anywhere else? I,m suprised any banks failed at all, maybe the lucky seven didn’t get the FM’s memo.

  • Euro-trash

    7 banks failed out of 91. Banks need to raise a few billion in capital. WSJ reports,

    European banks largely passed a round of government stress tests, with just a few institutions found to need modest amounts of new capital.

    But the overall strong grades, awarded to a banking system that for the last several months has lurched from crisis to crisis, raised questions over whether the monthlong tests were tough enough to be judged credible.

    The stress test results, intended to restore trust in the European banking system, showed that the 91 banks scrutinized could face €566 billion ($729.35 billion) in total potential losses in a deteriorating economic and financial environment.

    The tests found that seven banks would need to raise new capital to fortify their finances and weather a potential economic downturn or government bond crisis.

    Germany’s Hypo Real Estate Holding AG, ATEBank in Greece and five Spanish banks—Unnim, Diada, Espiga, Banca Civica and CajaSur—were the only institutions to fail the tests. Their combined shortfall would be about €3.5 billion, according to the Committee of European Banking Supervisors, which coordinated the tests.

    By contrast, analysts had estimated that the exams could reveal capital shortfalls totalling anywhere from €30 billion to €90 billion.

    “If you do a test and everyone in the class passes, you know there is a problem with the test,” said Selwyn Blair-Ford, head of global regulatory policy at FRSGlobal, a risk and regulatory reporting company.






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