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