ECB’s Comprehensive Bank Assessment Finalized

A considerable level of apprehension was noticeable in the financial press in recent days, as the ECB just finished its “stress tests” and its comprehensive assessment of 130 systemically important banks in the euro area. This time, the stress tests are a bit more interesting than previous exercises of this sort were.

Contrary to the whitewash attempts that characterized the laughable stress tests performed during the euro area’s sovereign debt crisis by the EBA (European Banking Authority), the ECB is forced to walk a slightly finer line. The reason is that it will become the regulator of these 130 large banks and will therefore be held responsible if anything goes wrong. On the other hand, the ECB is also eager to avoid a panicky market reaction to the results, and will therefore presumably try not to be too harsh in its assessments. In fact, looking at press reports, it certainly appears as though the criteria have been watered down quite a bit. Some observers argue that the ECB is far too beholden to political and market expectations to make its assessment credible (see also further below).

To this it should be noted that no fractionally reserved bank can be regarded as truly solvent, for the simple reason that such banks cannot actually fulfill their payment obligations to holders of overnight deposits. It works only as long as only a small percentage of depositors attempt to withdraw the money that they have been promised to receive “on demand”. Under normal conditions, this doesn’t pose a big problem, as banks continually receive new deposits and most deposit money tends to stay inside the system. Up to a point, a bank threatened by a run on its deposits can also rely on the lender of last resort (i.e., the central bank) to supply it with liquidity by discounting its securities.

Since money is nowadays a mere token signifying nothing, there is also no limit on its production. The ECB seems quite confident with regard to this aspect of the banking system, as its minimum reserve requirement for demand deposits stands at a mere 1%. In theory, the European banking system could multiply every deposit a hundred-fold by creating additional fiduciary media on the back its existing deposit base. In practice, this is highly unlikely to happen, but it shows that it is nowadays not seen as necessary anymore to even pretend that deposits are sufficiently “backed” with standard money (in the fiat money system, standard money = currency and bank reserves with the central bank).

The banks themselves have already received the results of the ECB’s assessment yesterday, but they will only be made public on Sunday – apparently the intention is to avoid roiling the markets. European bank stocks have recently tested an important short term technical support level and rebounded from there over the past few days:

Euro-stoxx Bank Index, daily – click to enlarge.

Much Ado about Nothing?

As the FT reports on the ECB’s comprehensive assessment of systemically important banks:

“It will be a delicate balancing act. On Sunday, the European Central Bank will unveil results from the health checks it has been conducting on 130 euro zone banks. Regulators need to prove to investors that they have been vigorous in their balance-sheet probe, while not triggering shock waves in financial markets already nervous about the euro area’s deteriorating outlook.

Amid intense speculation about the outcome, some investors were on Thursday questioning whether the announcement will mark the cathartic moment that has been predicted. Philippe Bodereau, global head of financial research at Pimco, estimates that 18 banks would fail the ECB’s stress test, based on his own reverse-engineered calculations. But he said they were mostly small operators.

“If it is a narrow margin on something that could go either way, I think it will be in the ECB’s instinct to tweak it more towards the interest of the banks,” said Mr Bodereau. “As a bond investor, the ideal scenario for me is if there are lots of failures and that forces big equity raisings. But I don’t think that will happen.”

Analysts at Berenberg believe any rally in European bank stocks after the results next week will be shortlived, arguing: “There is evidence that the ECB has compromised to meet political, bank and market expectations. Thus, the real issues remain unaddressed.”

The Comprehensive Assessment of the banks was launched last year and has involved thousands of officials, accountants and consultants. Banks will be privately notified of results of the exercise, comprising an Asset Quality Review and stress tests, on Thursday, with full publication to follow on Sunday.

Among the banks seen by analysts as most likely to fail the stress tests are Banca Monte dei Paschi di Siena and Banco Popolare in Italy, IKB in Germany, Millennium BCP in Portugal and Permanent TSB in Ireland. Unlisted German banks, as well as smaller banks in Portugal, Greece and Italy, are viewed as the most vulnerable.

Fitch Ratings says that many banks that do “fail” could be technical failures only, given that some have already addressed capital shortfalls this year or that capital can be easily found from within the banking group.

The ECB has argued that its stress tests have already been a success, as they have encouraged the region’s lenders to clean up their balance sheets in advance.”

(emphasis added)

It is true that European banks have increased their tier 1 capital significantly over the past 5 years. In that sense, many banks are indeed more resilient these days, so the ECB is not entirely wrong when it claims that its stress tests have had a salutary effect by forcing banks to strengthen their balance sheets ahead of the review. This is also one of the reasons why bank lending to the private sector in the euro area has declined so much – by lowering their exposure to “risk assets”, banks can increase the percentage of equity capital as well. Many banks have preferred this method to further shareholder dilution, and a positive side effect of this was that additional malinvestment due to renewed credit expansion ex nihilo has been somewhat held in check in the euro area.

Unfortunately, the banks have at the same time vastly expanded their holdings of (often dubious) government debt, and euro area public debt has continued to explode into the blue yonder both in absolute and relative terms (i.e., there actually is no “austerity” on a euro zone-wide basis). Thus, while inter-temporal discoordination of the economy’s capital structure may have been held in check, it has been replaced by intra-temporal discoordination. The end result is still a production structure that is at odds with actual consumer preferences.

In the context of the stress tests, if one e.g. considers that in Greece – a country with just 11 million inhabitants – non-performing loans now amount to some €90 billion, one wonders how any Greek bank can possibly pass the test. As the recent bankruptcy of Banco Espirito Santo in Portugal has shown (see: “Big Portuguese Bank Gets Into Trouble”, and the follow-up “Fears Over BES Escalate” for details), there apparently still lurk a great many skeletons in the banking closets of the euro area’s peripheral countries.

However, an even bigger problem may well consist of what is actually regarded as “risk free” assets, which form the basis of so-called tier-1 capital at banks. For instance, banks are not forced to provision for any of the risks inherent in sovereign bonds. This is in spite of the fact that the euro area’s debt crisis of 2009 to 2012 was largely a sovereign debt crisis. At the time, there was a lot of talk about reassessing the riskiness of government issued paper, but all of these debates have in the meantime disappeared into the memory hole.

Government bonds thus continue to enjoy a risk-weighting of zero, even those of euro area sovereigns with a credit rating that suggests their debt remains dubious at best. Consider e.g. Italy’s debt trap in this context. In spite of running a “primary surplus” at present, the government’s debt mountain continues to grow due to the sheer size of the debt it has already amassed in the past- even with interest rates at rock bottom. We’re not quite sure in what sense this debt can be considered “risk free”. If anything, it looks extremely risky to us.

Italy’s perennially growing government debt-to-GDP ratio – click to enlarge.

Banks are also forced to conform to new regulations on “liquidity coverage”. These prescribe that they need to hold a liquidity buffer that ensures they can service their obligations for a 30 day period in the event of a crisis. The problem is once again that many of the instruments regarded as “liquid” may be riskier than appears at first glance. For instance, the risks inherent in covered bonds backed by mortgages are surely not independent of real estate prices. In a great many European countries there are still vast real estate bubbles extant that have either not yet shown any signs of blowing up, or are only just beginning to do so (e.g. in France).

The point is that all of these instruments, including government bonds, depend on confidence. If anything happens to shatter this confidence, they will become illiquid and their value could change quite materially. In short, although the ECB’s stress tests will likely conclude that most large European banks are in reasonably good health after strengthening their capital base in recent years, their health remains a matter of perspective.

A long term chart (monthly) of the Euro-Stoxx Bank Index. In spite of the big rally since the 2012 low, bank stocks remain far below the peaks recorded in 2007 – click to enlarge.

Conclusion:

We doubt that there will be a great many surprises when the stress test results are made public on Sunday. It has e.g. already leaked out that Germany’s banks have passed, and investors are generally aware which banks are likely to have failed and will be faced with demands to add to their capital. The effect on financial markets should therefore be negligible. Nevertheless, after decades under a pure fiat money regime that has allowed debt of all types to grow to an unprecedented size, it is utterly vain to talk about the banking system being “safe”.

As a rule, new regulations designed to increase the safety of this inherently unstable system are focused on whatever went wrong last time around, which is usually not what is going to go wrong next time. It is moreover widely held that more and more regulations are needed to lower systemic risk. However, the increasing complexity of the regulatory framework mainly tends to create a false sense of security, and will very likely increase rather than decrease systemic instability.

The only solution that would be guaranteed to work would be to bring money and banking fully back into the ambit of the free market. The rules required to ensure the smooth functioning of a free banking system employing a market-chosen money would fit on a small napkin.

Charts by: BigCharts, Tradingeconomics