Healthy banks? Stress tests will do little to boost confidence

The European Central Bank is poised to publish the results of its bank stress tests on 23 July, but investors are sceptical about whether the measure will restore stability to the markets.

The Committee of European Banking Supervisors (CEBS) has said that the stress test will focus on 91 Continental banks, including 27 Spanish institutions, 14 in Germany and six in Greece, with the combined total representing 65% of the European Union banking sector.

ECB president Jean-Claude Trichet said the tests are designed to assess the banks’ ability to ‘absorb possible further shocks’, such as a weak economic recovery and sovereign risk.

Not tough enough

However, the rigour of the tests has come under fire in many quarters, with investors saying that they are not demanding enough and as such will do little to restore confidence in the sector.

‘There are several reasons to think that the tests will not restore confidence in the banking sector or prompt a revival of bank lending,’ said Jennifer McKeown, senior European economist at Capital Economics.

‘First, they will only cover the EU’s largest banks and we will still know very little about 35% of the sector, including the region’s smallest banks about which market concerns have probably been greatest.

‘Second, the outcomes that will be considered are nowhere near bad enough. Admittedly, the “adverse scenario”, which assumes that the level of GDP will be 3% lower by the end of 2011 than the European Commission’s central forecast, is worse than our own relatively gloomy forecast.

‘We expect the eurozone to expand by about 1% this year and 0.5% in 2011, while it implies EU growth of 0.5% or so in 2010 and a small contraction in 2011.  But, as the latest recession has shown, this is far from the worst case.’

Limitations

Indeed, the EU economy shrank by 4.1% in 2009 and while no-one is predicting such a bearish outcome this year, the figure serves to underline the limitations of the stress test.

The sovereign risk component of the test has also come under fire for similar reasons. The apparent scenarios being assumed are write-downs of 16% to 17% in Greek government bonds, 8% on Portuguese sovereign debt and 5% on Spanish bonds, with only negligible ‘haircuts’ on German Bunds.

However, as Marc Chandler, global head of currency strategy at Brown Brothers Harriman, points out: ‘The recovery swaps market is pricing consistent with a 40% recovery rate, equating to a 60% loss on Greek bonds defaulting or restructuring.’

Sceptical on scale

Bruce Packard, financials analyst at Seymour Pierce, is equally sceptical about the scale of the defaults being factored into the stress tests.