Testing the European banks' stress tests

Testing the European banks' stress tests

by The Economist online | BERLIN

IT TOOK a while but Europe’s committee of bank supervisors has finally agreed on some basic criteria that should be applied in a series of co-ordinated tests of the ability of the region’s biggest banks to withstand a downturn. The idea of testing banks’ ability to withstand various scary scenarios is a sensible one. There is still some debate as to how much to credit the stress tests carried out in America for restoring trust in its biggest banks, but few people think they were a bad idea. Their big advantage is that they can help to address a fundamental flaw in the financial system: namely that it is difficult for outsiders to assess the health of a bank. In such circumstances it makes a lot of sense to invite outside examiners to rummage about in filing cabinets and ask difficult “what if” questions.

The trouble, however, is that stress tests only restore confidence if the questions are tough enough to be realistic but not so tough that too many banks fail them. They have to reassure markets that banks will survive not just the most likely of scenarios but also slightly less likely but still possible ones.

There is also a danger, however, in setting the bar too high, for markets would also be unnerved if many banks were to fail their tests. In America a reasonable balance could be found because markets were providing some indication of expected defaults and losses on toxic assets. In the case of Europe the issue is complicated by market interventions and politics. It is clear that the tests have to somehow take into account the possibility that one or more European countries may default on their debts. These may not be likely outcomes, but they are possibilities that have the markets on edge. Yet there is great reluctance across all European institutions to explore explicitly such a possibility.

Instead the committee of bank supervisors has suggested applying a discount, or “haircut”, to some European bonds that is supposedly based on market expectations of default. Yet because the European Central Bank is buying sovereign debt to help prop up prices, markets are not giving a clear indication of expected loss levels. As it stands the tests seem unlikely to offer much reassurance on the consequences for banks of one or more sovereign defaults. Without answers to that question, there seems little point then in doing the tests.