Financial oversight

When EU banking stress tests become meaningless

FILE PHOTO: A man walks past Deutsche Bank offices in London
Ready to weather the storm. Source: Reuters

Feelings ran hot, then ice cold: The last two weeks have been something of an emotional roller-coaster for the management team of Germany’s largest lender, Deutsche Bank. First, share prices fell to an all-time low thanks to frustrating quarterly results. Then there was joy, as word came that a US investor Hudson Executives, bought 3.1 percent of the bank and backed the management’s plans. Then finally, there was again disappointment as European banking stress tests showed Deutsche Bank ranked near the bottom.

At first glance, the weak results of the stress tests seem like a blow for Deutsche’s new CEO, Christian Sewing, who started the job last April. Yet again, the bank looked less than sterling in front of financial oversight authorities. But look more closely and it becomes clear the stress testers went to great effort to show what everybody already knows: Deutsche Bank has a profit problem.

In fact, Deutsche’s ranking spotlights the problem with these European-wide stress tests. What exactly are the financial oversight authorities after, when they wildly gather data from different corners and concoct various crisis scenarios every two years? They end up either with those very apparent conclusions – the things everybody already knows – or with unrealistic assumptions that are too closely aligned with political desires. The result: Reports from our European financial overseers fluctuate between the arbitrary and the banal.

To really understand the results of the stress tests, you have to look at their underlying assumptions. Because that is where the problems start.

Germany’s faster recovery

Using balance sheets from the end of 2017, the European Banking Authority, or EBA, tests how each bank would withstand an economic crisis, during which housing and consumer prices fall dramatically while unemployment rises.

In reality, though, each sovereign European country would experience these issues differently. For example, while the scenario suggests that an economic crisis would have a strong impact on the German economy, it should have a milder impact in Italy – the argument being that Germany’s export-driven economy is more vulnerable.

That is only half-true. The last financial crisis showed that, yes, the German economy suffers severe consequences in a downturn. But at the same time, it recovered much faster and resumed growth more quickly than others, as the global economic situation calmed.

Under the stress-test spotlight

It appears even more unrealistic when you examine the scenario’s assumptions on risk premiums. For example, the tests assume that for Italy, the rate of return on government bonds was going to go to 3.3 percent this year. But that is well below where the bonds are now, thanks to the Italian government’s fight with the European Union about its rule-breaking annual budget.

No wonder then, that Italian Finance Minister Giovanni Tria declared he was “satisfied” with the results of the banking stress tests. Two Italian banks didn’t do that well: Banco BPM and UBI Banca ended up fairly low in the rankings. But some of Italy’s most acute cases, like Banca Carige, were not even part of the tests. And when you look at it that way, the results are far from satisfactory. The Italian banks are sitting on €364 billion ($415 billion) worth of government bonds. The drop in the bonds’ value due to the budget debate saps bank equity and has locals anxious about a banking crisis in Italy.

This example alone feeds suspicions that European banking oversight authorities are under political pressure. There’s an insoluble conflict of interests for the European Central Bank, which assists with the EBA’s stress testing, alone. As the enforcer of the EBA’s rules, the European Central Bank, or ECB, must identify weaker banks without prejudice and clean them up. However, in terms of monetary policy, the ECB also cares about the financial stability of the euro zone, and fears any dramatic remedy could set off a new sovereign debt crisis in a country like Italy.

Not perfect but necessary

Despite all the existing issues with the stress tests, you cannot damn them completely. The reports are used by oversight authorities to force certain banks to comply with stricter capital requirements. And it is also true that, over the past few years, European banks have improved their capital-to-equity ratios after such stress tests.

The question also arises: Should European overseers move closer to the US example in the future? There the stress tests are more dynamic and predictive because they work with more realistic and fewer historic estimates. Additionally, the US researchers provide results in both quantitative and qualitative form, so that any weaknesses in risk management can be uncovered.

In themselves, the stress tests can be a good thing: they inform investors, politicians and other interest groups about the state of their local banks. But if there are doubts about the methodology or if the stress tests simply deliver something we already know, as in the case of Deutsche Bank, they become meaningless.

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