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Main Content
Stress Tests: A Boon for European Banks?
On Friday, the EBA published the results of its long awaited stress tests designed to test the resolve of the continent’s banks should they be once again faced with meltdown
But, with many questioning the credibility of such models, how should banks react to the news?
During the heady days before the 2007 financial crisis, words such as ‘risk’ and ‘compliance’ were of little interest to European bankers. Capital could not generate wealth if kept safely in coffers – far better to relentlessly lend money out to ensure that the unprecedented growth which was the hallmark of that era continued apace. Governments too were caught up in this laissez-faire lending spree, with the tax income generated by banks allowing them to spend quicker and deeper than had ever been permissible before. Then, of course, came the fall. Funds quickly dried up across the globe, and bankers found it increasingly difficult to find the funds required to allow their institutions to function. Public anger followed, leading in turn to government embarrassment, particularly after it became clear during the endless number of credit crunch post-mortems that the problems had not stemmed from deliberate flouting of the rules on the part of bankers, but rather a lack of coherent regulation. What has followed since has been biblical in its proportions; a plethora of reforms and guidelines designed to avoid future catastrophes, with a range of committees and institutions to ensure that the new rules are respected.
Enter the European Banking Authority (EBA), the London-based agency set up by the European Union and charged with ensuring the establishment of pan-European criteria for banking stability. A simple enough task, it would seem, given that all parties have a vested interest in a financial sector with a degree of protection from implosion. And yet, by viewing the reaction when the EBA published the results of its 2011 stress tests on Friday, one would, at first viewing, think that many in the banking industry would rather see collapse than stress test regulation. Last week’s mutterings that the EBA had been far too intransigent in setting its conditions had become catcalls by the time German bank Helaba pulled out of the process in a row over whether hybrid capital should be included in calculations of tier one capital ratios. On the other hand, by the time the markets opened on Monday, the EBA was openly ridiculed in financial centres across the continent over its failure to include provisions for a Greek default on sovereign debt, an ever-more likely scenario.
Unfortunately for the EBA, these criticisms have served to some extent to undermine its own credibility; a bank reneging on promises to involve itself in the process with the tacit support of German officials is a PR disaster for the organisation and the refusal to countenance a Greek default seems, at best, optimistic and at worst irresponsible. They also serve to highlight the political quandary of the EBA; overly stringent testing may lead to a run on already weakened banks whilst if hard questions are not asked the entire exercise becomes fruitless – last year the EBA gave banks in the Irish Republic a clean bill of health only to look on with the rest of the world’s regulators as they were spectacularly bailed out a few short months later. Such negative press, however, should not detract from the fact that the EBA is clumsily ushering a silent revolution in the banking industry, one which may ensure its future independence from the multi-layered government intervention.
Like almost all revolutions, this one has been affected more through luck than judgement, and is certainly more the result of limitations placed by EBA’s authority than what any bright spark based in its Broad Street headquarters has come up with. As a supranational regulator, the EBA lacks any real powers to enforce its edicts, save from the moral authority stemming from its position atop the European banking tree. It lacks ability to fine banks, ban traders and imprison board members, tools available to national regulators and, ultimately, court rooms alone. Thus, its only recourse in attempting to make sure that European banks tow the line is to very publicly denounce them when they err and hope that that they are punished on the world’s stock markets by falling shares as a result. Nowadays, few economists are total devotees of the founding father of economics Adam Smith – centuries of studying and applying his principles to the real world have led many to quote him only with caveats and reservations. Yet his mantra about the self-regulating nature of markets may be appropriate here; jitters in the stock markets should be able to force even the most hardened banks to sit up and take notice of the EBA, providing of course that the markets pay attention to the EBA – a fact confirmed at the close of business on the Monday following publication of the EBA’s results, by which time stock markets across Europe had plummeted.
The advantages of this ‘regulation on the markets’ should be obvious to all those involved in the banking sector. Banks would be able to avoid the humdrum and protracted negotiations about how they should be structured post-credit crunch. In turn, governments would be able to delegate such powers to the EBA, safe in the knowledge that any transgressions would be highlighted during banking stress tests. Moreover, regulation at the European level not only allows for a pan-European norms – a good thing from a regulatory point of view, but also protects the governments of member states from accusations that their relationships with bankers are too cosy. Finally, alternative systems, whereby banks and governments build consensus about what steps they should take have so far proved much less effective than the stress test shock tactic. Anybody unfortunate enough to have witnessed the torturous (and on-going) negotiations between British banks and Her Majesty’s government – commonly (and perhaps ironically) known as ‘Project Merlin’ – would be able to testify to the fact that finer points of such discussions often drag out ad nauseum.
Of course, this revolution is not without its flaws, the primary one regarding exactly what conditions stress tests should seek to examine; much noise has been made about the particular stresses that should be tested – much has been made of the EBA’s insistence that banks should make sure the mistakes of 2007 are not repeated rather than safeguard against potential problems of the future. Clearly, no one institution can foresee what stresses individual banks will be placed under in times yet to come. But at the same time, such details can be tweaked in future and adapted according to events – establishing a precedent of regulation with stress testing is far more important. Moreover, in such cases it would be up to traders to make the decision about how accurate such modelling is – indeed, they already did so when, after Helaba dropped out of the stress test process, they did not collectively scramble to offload the banks shares. Whilst this system would inevitably lead to boom bust patterns in stock markets on the days results of stress testing are published, one hopes that as markets got used to publication of regular data, such nose dives would become mere blips. Fearing a stock market crash has never been and should never be a justification to hide information.
For European banks, there is only one certainty in the field of risk and compliance - that the continent’s governments, regulators and citizens will want some guarantee that there will be no banking disasters in years to come. Of course, this is not possible. But, if they acquiesce to stress testing and the type of regulation that entails, they could reassure these nervier parties and may even be able to regain some of the cherished independence so treasured in the years before the 2007 crunch. It may not be a return to the glory years at the start of the century but it will at least allow them to once again set about generating a great deal of wealth.