European Stress Tests: A Joke

The handling of the Euro-crisis has been much, much worse than Bernanke and Geithner's handling of the initial US collapse. Despite the Fed's recent bizarre unwillingness to engage in further monetary stimulus, Bernanke and Geithner handled bank stress testing about as well as could be expected. They could have been stricter, certainly, but they did at least evaluate a number of different downside scenarios, even if they avoided catastrophe scenarios.

 

However, the Euro treatment of its crisis has been bizarre. First came Trichet's plea yesterday for the rest of the world to engage in austerity. While much of Europe requires austerity right now because they're having legitimate debt crises, Trichet should be begging the rest of the world to spend as much as possible because it would stimulate European exports and help them out of the crisis. The only plausible reason to beg for that is so that they can politically help Europe feel like it's suffering along with everyone else in order to avoid public criticism (or emigration). While I understand the political sensitivity of his situation, shooting your own foot off because it's easier for Europeans to pretend that the rest of the world was as fiscally irresponsible as they were is a stupid argument.

 

 

Today came the bank stress tests, which sadly, don't seem to be worth the paper they're written on.

 

A couple weeks ago, it came out that stress tests were examining banks under the assumption that Greek debt would pay 83% of notional principal and Spanish debt would pay 97%. These are laughable assumptions, given that Greek and Spanish debt are trading WELL below those levels, and even if you think the market is unduly pessimistic, they still should have tested based on market assumptions.

 

Then the results come out today and they ignore the possibility of any sovereign defaults and they ignore the results of a dissolution of the Euro, because European authorities (at least publicly) feel they need to dismiss these concerns as impossible. The only stresses applied were defaults on privately issued assets.

 

While it's useful to have detail on the Greek, Spanish, Portuguese, etc. sovereign debt holdings on banks, the stress tests did not apply anything remotely approaching the most stressful set of likely conditions, which is what you'd want to see a stress test do.

 

7 of 91 banks STILL failed. Should we be looking at ALL European banks as compromised, given the likelihood of a sovereign default somewhere, and the very real possibility of Euro dissolution? More pertinently, wasn't the point of the stress tests to get investors to stop freaking out about the possibility that all European banks are compromised? If a stress test is designed so that it inspires no confidence in banks that passed, but scares the shit out of us when banks fail and actually affects our perception of passing banks because of failure rates despite lax assumptions, doesn't that make the stress tests useless?

 

The US had no banks fail, or come close to failing, much stricter stress tests, despite similarities in the level of government recapitalizations/bailouts (and in many cases, less recapitalization and bailout). Say what you like about irresponsible mortgage lenders (hi Countrywide!) and poor credit structuring by banks, but in terms of capital regulations and bank leverage, US banks performed much better in the boom years than European ones despite allegedly being way more irresponsible than their more-regulated European brethren. This should be something to think about for the "more regulation" crowd.