Just a Flesh Wound
'Doctor, how am I? Tell me the truth.'
'Well, you have a mild case of cardiac arrhythmia, your cholesterol is about thrice of what it should be, your blood pressure is off the scales, and if I'm not mistaken, there's a spot of beginning, how shall I put it? Kidney and liver failure. Alas, unless your heart actually stops beating, I think you'll be fine. Of course that brain tumor might get you as well, but a committee of doctors is currently busy solving that particular problem, so we can safely ignore it for the time being. As causes of death go, it's too improbable anyway, right? I therefore pronounce thee to be in ruddy health. Take two aspirin and call me tomorrow.'
We're not quite sure what the EBA's (European Banking Authority) stress test of European banks was supposed to achieve. As far as public relations exercises go, the effort is a monumental failure. Recall that the first European bank stress test was immediately revealed as a sham when a number of Irish banks that had passed it collapsed a mere few weeks later. The results of the first test had of course been received with widespread incredulity, which the insolvency of Ireland's banks soon vindicated. This time the authorities attempted to deliver a more rigorous test, one that would produce enough failures to be credible, but not so many as to induce a panic. As we noted in 'Hurrah, We're Saved Again' in late June, these goals were formulated well in advance, with anonymous sources from the ECB quoted by Reuters noting that
In the drive for credibility, the EBA, which runs the tests and the ECB, which sets the economic scenarios, have pushed for more banks to fail than last year's seven.
"How many do we expect to fail? I would say 10 to 15," said one senior euro zone central banking source.
The EBA wants the number of banks that do not pass the tests to be around that level to show the examinations were serious, said a second source, adding the authority did not want to push for more, for fear it could spark panic.
"In order to demonstrate that it is credible, the EBA would need to show that the number of bank failures is significant, without being substantial," said the source. "A number in the teens is about right."
Given such advance comments, the desired credibility was likely already lost before the publication of the stress test results. The actual results that have now been delivered quite possibly will serve to damage it further. Of 90 banks tested, only eight failed to pass the test's main requirement of keeping a core tier one capital ratio of 5% intact under the proposed 'stress' scenario. An additional 16 banks fell in the 5%-6% range, which is to say, they almost failed to pass.
We should interpose here that the stress test was certainly not an entirely useless exercise, even though it will likely fail to boost confidence. Its usefulness consists mostly of the fact that it forced the banks concerned to reveal their various exposures in great detail, which makes it easier for outsiders to analyze their situation (we are sure we will have occasion to refer back to these data).
The immediately obvious conclusion is that even by the not very onerous assumptions of the stress test, some 24 out of 90 banks, or nearly 27%, must be regarded as being in danger of failing if economic conditions worsen markedly.
Let us suppose that the worst case comes to pass and these 24 banks do in fact fail. Would the stress test results then still be applicable to the banks that passed? After all, one of the main problems the banking system faces is its interconnectedness. There is e.g. the ever present 'Herstatt risk', or more generally, settlement risk (the term stems from the 1974 failure of the German Herstatt bank, which was a big player in the forex markets and left its counterparties dangling when its banking license was one day withdrawn after the market close in Germany). When banks stopped trusting each other in the 2008 crisis and interbank lending rates exploded, it was precisely because of a perceived increase in this counterparty risk. As has been seen in the period August 2007 to March 2009, central banks will pump 100ds of billions into the system to avert a scenario of cascading cross-defaults when the payments system becomes paralyzed. As money supply data from this period prove out, it is not possible for these interventions to be neutral in their effect on money supply growth.
In addition, it is not possible in a fractionally reserved banking system for banks to pay all or even a large fraction of their extant demand deposit liabilities to depositors in case of a bank run. The legal privilege that allows banks to treat money that has been warehoused with them as a 'loan to the bank' which they can use for their own business activities means that depositors are exposed to a risk they have in reality not contracted for. Government guaranteed deposit insurance schemes have been set up everywhere, enticing depositors to ignore this risk and enabling commercial banks to engage in nearly unchecked expansion of credit and deposit money. It goes without saying that when governments themselves are threatened with going bankrupt, many of these deposit insurance schemes are not worth the paper they are printed on.
Why The Stress Test Is A Farce
The biggest problem with the stress test is that it glossed over what is currently the by far biggest problem for the European banking system – namely the collapse in peripheral sovereign bonds and the very real risk of one or even several sovereign defaults occurring in the not-too-distant future.
In short, the number one problem was treated as though it didn't exist, or as though it were only of marginal importance. There was no choice but to treat the problem in this manner if the test was to hew to the current 'party line' of the eurocracy, which holds that no sovereign defaults will be 'allowed'. This is considered an important plank in keeping up confidence in the fractionally reserved banking system and the mountain of government debt that is deeply intertwined with it.
In the stress test, regulators differentiated between two sets of books – the 'trading book' and the 'banking book' of the tested banks. Not surprisingly, the vast bulk of government bonds held by the banks resides in the 'banking book', where it is presumed that they are held to maturity. As long as a sovereign debtor is not officially in default, it is further assumed that these bonds will be redeemed at par. The haircut applied to this exposure was therefore zero. After all, in the official version of the future, there simply won't be a sovereign default (the EBA does demand provisioning against risk in the banking book, but as noted further below, these provisions are of negligible size).
Haircuts were however applied to the banks' trading books. As an example of how far removed from reality these haircuts are, consider that the biggest discount – applied to Greek government debt held in trading books – was 25%. Greek government debt meanwhile is trading at 50% and more below par in the markets. In other words, not even the sovereign bonds held in trading books were properly marked to market.
Of € 377 billion in loan loss provisions held by the 90 banks in total, only € 11.5 billion thus relate to their sovereign debt exposure. As a reminder, the total exposure of European banks to Italy's government debt alone amounts to € 1.2 trillion. € 11.5 billion represents not even one percent of this amount, basically it is what the banks could lose in the first ten to fifteen minutes of a bad hair day in the bond markets.
Provisions for loan losses per the EBA stress test, for various types of assets held by the tested banks. Only slightly below € 11.5 billion have been reserved for sovereign credit risk. This seems bizarre given the current state of the sovereign debt crisis.
The EBA acknowledges this problem – to quote from its report:
“It is the assessment of the EBA that bringing all banks above the 5% threshold is necessary but not sufficient to address potential vulnerabilities at this conjuncture. Further actions are needed to make sure that EU banks’ capital positions are strong enough to weather possible further shocks. While the features of the adverse scenario are still in line with the commitment of the European Union to prevent one of its Member States defaulting on its liabilities, a further deterioration in the sovereign crisis might raise significant challenges, both on the valuation of banks holdings of sovereign debt and through sharp changes in investors’ risk appetite. In turn this could lead to funding pressure (in terms of both cost and availability) affecting some banks’ earning power and internal capital generation capacity which, if not promptly addressed by the banks and their national authorities, could further affect market confidence in these banks.”
One example of the 16 banks that passed the stress test just barely (with a tier 1 capital ratio between the 5% threshold and 6%) is Italy's Banco Popolare (BP). As the EBA report points out, the authority expects the 'barely passed' banks to likewise take measures to strengthen their capital positions – in addition to capital that has already been raised by a number of these banks. The stock market's assessment of many of these weak banks has been devastating – Banco Popolare's share price is at present down some 94.5% from its 2007 high.
The details of the test on BP can be . Under the EBA's 'adverse scenario', BP's tier one capital ratio would fall to 5.7% from the current 5.8% by 2012, whereas under the 'baseline scenario' (nothing bad happens from here on out) it would rise to 6.8% – this includes capital raisings and other mitigation measures that have been taken between end December 2010 and April 2011. As the tables show, the bank has total exposure to credit risk (ex sovereigns) of € 128 billion, of which € 12.8 billion are currently in default (all numbers rounded).
While sizable provisions for loan losses have been made, there are almost no provisions for the bank's sovereign debt exposure. This exposure amounts to € 12.4 billion, of which the vast bulk (€ 11.8 billion) consists of Italian government debt. These exposures compare to core tier one capital – including government support measures – of € 5.5 billion and total capital of € 10.1 billion (note that 'risk weighted assets' amount to only about € 95 billion, hence the tier one core capital ratio of 5.8%).
The share price of Italy's Banco Popolare, which passed the stress test, but only by a small margin – click for higher resolution.
Italy's 10 year government bond yield ended the week at a fresh 10 year high of 5.757% – in spite of a decision to than originally envisaged. So far, the markets remain unconvinced – click for higher resolution.
Of the banks that actually failed the stress test, five were Spanish cajas, two were from Greece and one from Austria (the paucity of Greek banks in the 'failed' category is a direct result of the generous assessment of sovereign risk). Already national regulators are protesting the EBA's choices of what should be included in core tier one capital and the stress test's allegedly 'severe assumptions' (2008 never happened, apparently).
The Bank of Spain has e.g. published a (pdf) on the EBA's stress test report and comes to the conclusion that:
“No additional capital injections are required by any Spanish bank or caja as a result of the stress test”
This is obviously not what the stress test says.
The tone of the Bank of Spain's comment is generally along the lines of 'the adverse stress test assumptions were too stringent and/or extremely unlikely', the threshold for minimum core tier one capital was 'set too high' and moreover, the stress tests in any case only serve as a sort of guideline, while supervisory agencies (such as the Bank of Spain) will have to consider other factors not captured by the test, which should also count in the determination of whether additional capital needs to be raised by the banks concerned.
In short, the EBA might as well have skipped Spain – it isn't going to do anything as a result of the five failures. Let us amend this comment by noting that we do agree with one point the Bank of Spain makes in its comment and which we also acknowledged above: the publication of the details of the stress tests has increased transparency and enables analysts to judge the position of the banks by considering the effects of their own scenarios.
Spain's 10 year government bond yield ends last week at 6.07%. From a purely technical perspective, a target of 7.5% seems feasible – the level that is per experience the threshold at which debt rollovers become difficult due to the increasing cost of servicing the debt.
While national regulators are accusing the EBA of undue rigor, market participants will likely come to the exact opposite conclusion: by largely ignoring the vast increase in sovereign debt risk, the stress test fails to properly reflect the risks to the euro area banking system. An important point worth mentioning are so-called 'second-order effects' that the EBA admits it did not address.
The comment to this effect from the stress test summary is worth quoting in full:
“The approach followed in the stress test, of holding provisions against sovereign debt in the banking book, remains consistent with the current situation and in line with some of the proposed options currently being discussed for vulnerable sovereigns. It is also in line with the commitment of the European Union to prevent one of its Member States from defaulting on its liabilities. The EBA understands that market participants, in particular, have raised concerns on EU banks’ ability to absorb the impact of a further deterioration´of sovereign debt in certain Member States.
Given the distribution of the exposures described above, the direct first-order impact, even under harsh scenarios, would primarily be on the home-banks of countries experiencing the most severe widening of credit spreads. In such cases the capital shortfall should be easily covered with credible back stop mechanisms such as the support packages already issued or being defined for Ireland, Portugal and Greece. In this context these countries have announced capital enhancement measures requiring banks to hold capital to a higher level than that used for the EBA’s EU wide stress test. Additional capital strengthening measures have been, and will be, announced to ensure this.
It should be highlighted that the assessment of the direct exposures does not take into account any second-order effects. Such effects, including more general changes in investor perception, challenges in funding across a broader set of EU banks and the impact on non-bank counterparties may be more significant.”
There is evidently a great deal of wishful thinking on display here. The assumption that “the commitment of the European Union to prevent one of its member states from defaulting on its liabilities” is an immutable condition that requires no further consideration appears almost audacious at the moment. What if the recent spreading of contagion to the government bond markets of Spain and Italy is not a fluke? Ironically, the risks are likely to increase in proportion to the eurocracy's presumed willingness to bail out fiscal offenders. If Ireland had decided to let its banks fail and Greece and Portugal had gone through an orderly debt restructuring, their bondholders would have had to absorb large losses, but by now these countries would likely be on the road to recovery (see Iceland as a pertinent example). The fact that it was decided to try to bail out all and sundry by propping up unsound credit and extorting tax payers to make bondholders whole has made it much more likely that in the end a total catastrophe – a disorderly dissolution of the euro area – will result. There is nothing wrong with 'austerity' in principle, in the sense of government expenditure being reduced. Alas, it should be part of a package of market-friendly reforms, ranging from lower taxes to the repeal of onerous regulations. There is no point in pressuring wealth generators into the service of bondholders who misjudged the risks they were taking.
As to one of the above mentioned 'second-order effects', we want to highlight the current composition of funding of bank assets in the euro area:
Sources of funding of euro area banks. Everything but the green wedge is subject to 'second-order effects' (also known as 'panic').
Maturity spectrum of wholesale and interbank funding in the euro area – the blue portion of the 2010 funding stock matures after 2012. Note how big a portion consists of very short term funding – precisely the type that tends to get withdrawn very quickly in extremis. Note that among the wholesale funding sources there are vast amounts of commercial paper bought by US money market funds, which are reportedly getting antsy of late over their exposure to euro area banks.
While wholesale and interbank funding sources tend to dry up first in the event of a crisis, the stability of customer funding can not be assumed to be immutable either. As we have seen in Greece, depositors aren't necessarily waiting around to see how things turn out for suspect banks and insolvent governments. The big depositors usually flee first, as their deposits exceed the amounts guaranteed by deposit insurance schemes. In the case of the Greek banks, smaller depositors have also increasingly decided to withdraw their deposits – as there is now considerable and well-founded fear that a bankrupt government will not be able to fund the deposit guarantees (and even if it did find a way to fund them, the process of recovering ones deposits from a failed bank is cumbersome and time-consuming). Anyone who has paid attention to Argentina's debt crisis in 2001 is probably well aware that the property rights of depositors are probably not sacrosanct in the event of a government default and widespread bank failures.
A comparison of core tier one capital ratios of banks in various countries over the last two years via the Economist magazine – US banks look best in this comparison table, which underscores how weak the capital positions of most euro area banks still are.
The latest stress test was no doubt far more rigorous than the first one that was so spectacularly revealed as a misguided PR exercise when Ireland's banks failed. However, its recommendations are not binding on the national regulators in the euro area and resistance to their implementation is already being voiced. Whether more bank capital will be raised as a result of the test remains therefore uncertain (although it may provide a certain degree of incentive to some of the banks named as being at risk). It is noteworthy that the first protest was issued by the Bank of Spain – where the current state of the real estate market and the associated collapse in the value of mortgage assets have likely left the banking system in far worse shape than has hitherto been officially acknowledged (see in this context the quote from economist Jesus Encinar we mentioned on Friday).
One noteworthy detail is also that Germany's Helaba Bank refused to take part in the test after clashing with the EBA over what should be included in its tier one core capital – presumably with the tacit approval of its regulator. As it were, “Germany's BaFin has denounced the EBA's methods and questioned its legitimacy”, as .
At the same time, the failure to properly account for the increasing risk posed by the ongoing plunge in the value of sovereign debt in parts of the euro area will leave the markets unsatisfied with the result. Market participants will likely continue to shy away from the shares of banks that appear to be probable candidates for raising additional capital (although in some bank stocks these expectations may already be discounted).
The only unalloyed positive from our point of view is the fact that there is now more transparency and it has become possible to quickly analyze the position of every bank that participated in the test. Murray Rothbard's contention that fractionally reserved commercial banks teeter on the edge of insolvency at all times has certainly not exactly been dispelled by this report.
A detailed overview of the data from each participating bank can be (clicking on a bank in the list will bring up a pdf report with all the relevant data).
A summary of the EBA's stress test report can be downloaded here (pdf).
It is interesting that the ECB seems fairly nonchalant about the recent decline in the narrow money supply gauges in countries like Italy, Greece and Spain and their stagnation in the euro area as a whole. According to the ECB this reflects the unwinding of excess liquidity provided during the 2008-2009 crisis. In this the ECB is clearly differentiating itself from the Federal Reserve, which won't allow its balance sheet to shrink (by contrast, ECB credit has steeply declined in recent months). As a supranational central bank with a clear mandate (namely to ensure 'price stability'), the ECB's policy will at times tend to be relatively tighter than it probably would be if it were a national central bank. This is notwithstanding the fact that its mandate makes no sense, does not keep the money supply from expanding as long as measures of consumer prices do not reflect said expansion, and the success or failure of the policy can not be properly measured anyway (we have previously discussed the dangers and futility of the price stability policy). The point we want to make is that there is actually a not insignificant risk of outright money supply deflation in several member nations of the euro area. This addendum is not the place to discuss the implications in detail, but it is clear that economic activity will decline in the near term under deflationary conditions, which in turn will make the task of hewing to their fiscal targets even more onerous for highly indebted sovereigns.
Needless to say, monetary deflation is not a condition one often gets to experience in a central bank-led fiat money system and we expect the ECB to eventually reverse course and resume monetary pumping.
Another little tidbit worth mentioning, one that highlights the callousness of the political class, is this article in the Guardian on the recent austerity package approved by the Italian parliament. Apparently the MP's decided to cut everyone's income except their own:
“Italian MPs are facing a backlash over multimillion-euro perks including trips to saunas and haircuts while the rest of the nation faces new medical charges designed to balance the national books.
Two days after the Italian parliament passed an austerity budget to keep the euro-zone crisis at bay, hospitals were carrying out two of the budget's key provisions – a new €10 charge for specialist appointments and a €25 fee for casualty visits, part of a series of measures expected to cost families around €500 a year.
But critics pointed out that as the budget was being debated last week, MPs for Silvio Berlusconi's Freedom People party quietly added amendments watering down proposed cuts to their own pay, currently €65,839 after taxes. Beyond that, benefits up to €117,000 a year that MPs can claim without showing receipts for housing, office staff, telephones and travel — on top of free rail and air tickets — escaped unscathed, as well their subsidised healthcare plan, which costs €10.1m a year.
A breakdown of the outlay on medical care published by newspaper La Repubblica on Sunday revealed Italy's 630 MPs are racking up €3m a year on dentistry, €257,000 on psychiatric bills and €204,000 on thermal baths.
"The government and opposition have again teamed up to protect privileges which are unequaled in Europe," said union leader Raffaele Bonanni.”
Psychiatric bills? Thermal baths? You couldn't make this up. We hasten to add that we don't necessarily want to pick on Italy's politicians specifically, even though they appear especially well-versed in legislating perks for themselves. The political classes and higher echelons of the bureaucratic classes are in clover all over Europe, even while they impose austerity on their citizens. There are some notable exceptions such as Ireland and the UK, where ministers, MP's and highly paid bureaucrats have seen their pay cut as well, although we are pretty sure the pay cuts won't land them in the poorhouse.
Given what citizens get out of their politicians and bureaucrats – ever more regulations, ever higher taxes and ever more abridgment of their liberties through undemocratic means such as the imposition of 'administrative law' by unelected bureaucrats, they aren't exactly getting value for their money. We are rather partial to the tradition of the Isle of Man, where new laws have to be publicly promulgated in both English and Manx, come rain or sunshine, in open air every year on Tynwald Day. This tradition is fairly certain to cut down on the amount of new and burdensome legislation.
The coat of arms of the Isle of Man, with the Manx triskelion in the center – the motto means: 'Wherever you throw it, it will stand'. Since new laws must be read out loud in public once a year, the danger of the legislature producing a EU-type thicket of laws and regulations is much reduced.
(Picture source: Wikimedia Commons)
Charts by: EBA, Bloomberg, Bigcharts.com, Economist magazine
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