Stress Test of European Union's Banks

Earlier this year, the bankers of Europe submitted information into a stress test

about their capital reserves to capture what kinds of securities their reserve funds were made of and how much they were fuelled by money based in volatile countries like Greece, Spain and Portugal. Despite the results of the stress test being reassuring initially, or so they appeared, it was found after a while that the information which the banking houses filled into the original CEBS templates was misrepresented. In the end, it seems that the EU banks' reserve structure is more exposed to contingent risk than we believed earlier.

A few weeks ago in July, a stress check was imposed on all E.U. banking houses by a regulatory body called the Committee of European Banking Supervisors to determine how ready they were to live through a future financial crisis. This test was mainly prepared as a way of measuring the EU banks' reserve ratios. In other words, the test was supposed to have provided an answer whether there is enough capital of a sufficient quality for the banks to fall back to. Several other non-EU countries undertook a similar test too LSM Insurance informed its readers about this earlier. The outcome of the test revealed that a handful of banks were in a less-than-favourable situation, yet the outcome in general was relieving and managed to solidify the investor trust in the European banking system in general. For those reasons, the Euro as a currency and other European countries not using Euro were thriving from a solid performance in the market.

However, that lasted but for a little while. In the beginning of September 2010, The Wall Street Journal published an indepth analysis of the test results reconciled with a glance at the examined banks' statutory statements. The Journal's analyses show that the banks often did not state all the necessary advice related to their debt, since the figures failed to entirely match those stated in the banks' quarterly financial statements. The banks did not lie. The banks simply neglected to specify the riskiness of their holdings correctly since the CEBS requisites were not specific enough to begin with.

Government bonds were in the past believed to be virtually risk-free. However, they have gained on importance. Greece's near-bankrupt status puts a larger risk on their debentures and as such, they deserve to be placed differently. Plenty of banks didn't acknowledge that important principle in their stress test reports. In addition to that, some banks would not even count in large segments of their capital holdings and said that those are highly volatile and actively traded. This way, they effectively improved their results in an uncontrollable fashion. Because every tested subject comprehended the stress test guidelines differently, each tested bank presented its capital with slight differences and that caused that the test results are drawing from varying bases. Therefore, they are hardly comparable and thus unreliable.

So, the main imperfection of the testing was how little extra information and explanations the banks share with the CEBS. It is unfortunate that the loose test requirements did not force the bankers to uncover useful pieces of data. The Euro took a severe shock as compared to other major currencies and has been recovering ever since. The confusing fact is that the CEBS is even now confident with the questionable rules despite evidence.

Hopefully, that regulators all over the globe will take their lesson from this slip and will make sure that any other rules and examinations are always thorough and reliable. Any further issues will insult the trustworthiness of the affected economy.

Stress Test of European Union's Banks

By: Lorne Marr

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