Not very stressful - that's the bad news

It was “much of a muchness for nothing very much”. Not that that itself is a surprise!

At the end of the day, the results drew attention to the leniency of the Eurozone stress tests and of the politicization of the process, rather than the robustness of the banking system. The feeling is one of let-down – having said that, the amount of this deflated feeling is probably not huge for markets – I would still like to watch for a day or two to be sure of that. I would not be surprised at all if we did see a drag on most markets.

Here is a quick summary of the Tests, parameters, results et al:

1. Coverage: 91 banks from 20 EU states, covering essentially 65% of the EU banking system and at least 50% of the national banking sector in each country. This includes banks that already receive government support.

2. Thresholds & Assumptions
- Capital: required capital ratio of 6% (Tier 1) under the “adverse scenario”.
Problem: this includes not only capital and retained earnings but also several hybrid instruments, part of which represent government assistance.

- Test parameters: based on a ‘double dip’ scenario, with Eurozone growth at -0.2% in 2010 (vs 0.7% in the benchmark case) and –0.6% in 2011 (vs 1.5% in the benchmark case); and various valuation haircuts to holdings of sovereign debt averaging 8.5% for the EU; ranging from 4.7% for Germany to 12.0% for Spain, 14.1% for Portugal and 23.1% for Greece.
Problem: no sovereign default accounted for (wasn’t this the original reason for these stress-tests?!)
Problem: haircuts applied only to trading books. But most sovereign debt is held in the banking books, in Greece’s case some 90% of its exposure. To me, this is a huge issue

- Test results: Given above, only seven out of 91 banks fail the test, five of which are Spanish cajas (plus Germany’s Hypo Real Estate and Greece’s ATE Bank). Many institutions narrowly passed.
Problem (announced as good news?): the total capital shortfall identified is a petty Eur3.5bn. This fits the pattern of denial by European policymakers and suggests the tests were calibrated in order to generate the desired result.

3. Transparency: The full sovereign exposure of each bank was not revealed despite previous announcements to this effect. Even the releases of national regulatory authorities only provide national aggregates. Germany reneged point-blank on its commitment to do so.

4. Credibility: Given the above-cited shortfalls, the tests significantly lack credibility even though they represent some progress over previous attempts to address vulnerabilities in the banking sector.

5. Communication: Lot of last minute confusion over timing, release of partial information throughout the day, release of German results prior to the announcement by CEBS etc suggest that communication could be handled better. Ex post there seems to be publicly aired disagreement on whether German banks were required to disclose their sovereign exposure by BaFin.

6. Next Steps: N/A
The issue of backstop plans has been rendered somewhat irrelevant given the benign outcome of the tests. Spain is one of the few countries that has a capitalization plan in place and on the basis of the results little further action is required elsewhere. This could yet lead to unwelcome surprises should other banks trip up in the future.

To me, regulators and policy-makers (and of course the politicians) have really gone out on a limb on this one. As close to a new definition of moral hazard as I have ever seen!

I am sorry, but The Emperor has no clothes

Invitation to a Party ... bring your Stress along !!!

Everybody is invited again …… to another Stress Test Party!!

So here we go once more, and whichever way you look at it, the Emperor has no clothes! The ones being really stressed in all this are the Regulators, and of course the markets, you, and !

I have an interesting email from Ash Jaidev, Northwestern University, (Class of 2012 Economics and History)

Quote

I was reading some article and thinking about bank stress-testing overall, and had some thoughts.

So Europe is in the process of developing stress tests for its banks, and there's all this talk about whether those tests are going to adequately reflect the nature of these banks… My problem is this. Let's suppose that there are 10 banks being tested, and all 10 banks "pass" the test. Everyone will think that the regulators' test was inadequate and didn't do enough to challenge the banks, and therefore no one will trust the test.

Now let's suppose that the same 10 banks "fail" the test. Can anyone conclude that the banks are actually all terrible, or that the test itself was too challenging and nit-picky?

What if a bank peforms badly on a stress test: market value and confidence in the bank declines, the bank suffers. The failed test caused the bank to decline, but the bank wasn't declining when the test failed it. Isn't that a paradox/endless cycle? What caused what?

Not sure if I'm being clear with all this. Point is, there is too much responsibility on behalf of regulators to create a stress test that adequately challenges banks while also managing expectations of investors and the market. It seems to me that it is impossible to do both!

Unquote

Cheers

Financial Reform

Here is a quick bullet-point view on the product of the Washington Sausage Factory….

➢ Oversight
o Financial Services Oversight Council
• Monitors financial markets
• Powers to determine tougher regulations across some institutions
• Power to break up large financial firms if they are deemed to pose a “threat”

➢ Consumer Protection
o Within Federal Reserve
o Power over credit cards, mortgages and loans
• Auto dealers exempt
• Regulators can appeal council by a veto 2/3 vote
• Case by case actions

➢ Federal Reserve
o Retains supervision over bank-holding companies
o Polices large interconnected non-bank institutions based on oversight council determination
o With council approval, power to break up large financial firms
o To be audited by Congress’s investigative arm for emergency lending around 2008 crisis.
• Low cost loans Fed provides to banks, and securities actions will be audited.

➢ Bank Capital Standards
o Higher risk and size based capital standards for Banks with more than $250 bio in assets
o Certain hybrid securities no longer to be considered Tier 1 capital
o Banks < $15 bio retain trust preferred securities, while large banks must phase them out

➢ Derivatives
o Majority to be on a regulated public exchange. Banks must spin off swaps/swap shops?
o Banks can continue to trade derivatives related to interest rates, FX, Gold and silver
o Banking companies have to use own non-bank funds to trade riskier derivatives
o Fed assistance for derivative trading losses prohibited

➢ Bank Restrictions
o Commercial banking ops not allowed to trade in speculative investments; Allowed up to 3% of capital in private equity and hedge funds (Volcker Rule) - Total? Per Fund?

➢ Corporate Governance
o Non binding common vote on executive pay
o Fed can set standards on “excessive compensation that is unsafe and unsound”

➢ Rating Agencies
o Agencies must register with SEC; increased liability standards
• SEC to study practice of credit rating shopping
• SEC to determine if independent board is needed

➢ Mortgage Risk
o Lenders must obtain proof from borrowers regarding income / repayment capacity
o Lenders must disclose max amount that borrowers could pay on ARMs
o Lenders banned from incentives to push people into high priced loans

➢ Insurance
o New Office of National Insurance with Treasury
• Monitor industry
• Coordinate international insurance issues
• Identify issues that would lead to systemic crisis

I say
- Could be better, but could have been much worse
- The proof is in the eating