Ostrich banking tests

Remember the EU's banking "stress tests", which were supposed to determine the health of the key financial institutions across Europe? The tests, that were published last summer, infamously cleared all Irish banks. Only a couple of months later, two of these banks were forced too seek help from the Irish state to avoid bankruptcy, which in turn forced Ireland to apply for a bail-out.

To say that this episode exposed some deep flaws in the stress tests is an understatement.

One problem was clearly that the tests weren't stringent enough. Banks were deemed by regulators to need only €3.5 billion of new capital - about a 10th of the lowest estimates that were out there.

Now a new round of stress tests is due to begin, and European Commissioner Michel Barnier has just informed us that the EU will announce the methodology next week.

In November, in the midst of the embarrassment about the Irish crisis, his Director-General Jonathan Faull declared that next time, it's going to be serious. He maintained that the new round of stress tests would be “demanding”, with the European Commission pushing for the tests to also assess liquidity of financial institutions (which seems like a pretty fundamental criterion).

This is actually a hugely important excercise. Europe will never get out of its euro-fuelled slump unless its banks come clean on their exposure to debt in various forms.

So what lessons have been learnt?

Well, there are crucial details of the tests that aren't known yet, but EU leaders and regulators haven't inspired confidence so far.

The European Banking Authority, that will carry out the stress tests, has already declared that the results of the liquidity checks (which will not be part of the stress tests but of separate risk assessments) "will not be published". The German government and Bundesbank have also resisted transparency, with Finance Minister Schäuble warning that "to prevent stress tests from producing more damage than good, we are ready to consider and discuss what of the tests will be published and what not."

This is of course a tricky balancing act - you can easily foresee an immediate run on a bank following stress tests results that aren't favourable. But then again, trying to hide the problem isn't a solution either.

And here we see the most contentious and problematic issue of them all - should a possible future restructuring or sovereign default involving, for example, Greece, be one of the test scenarios for banks?

European Central Bank President Jean-Claude Trichet appears to say NO, it shouldn't.

Financial Press Agency MNI suggests that

distinguishing between the trading and the banking books could mean that the tests will ignore the majority of banks' holdings of sovereign debt, since most Eurozone government bonds are held on the banking books.

This is critical since the debt and solvency crisis facing the eurozone is so intimately linked to the fate of Europe's banks that it's now impossible to separate the two. Clearly, one of the main fears of a possible eurozone default - or even break-up - scenario is the losses that European financial institutions would suffer, which in turn could take Europe right back to 2008 (or in the case of Ireland, 2010). Taxpayers would again be forced to step in to avoid a complete meltdown of the financial world as we know it.

The lesson from the most recent crash must clearly be that financial institutions and governments alike need to plan for the worst.

Even if EU leaders don't believe that a default or break-up is desireable or likely, the worst thing they could do is not to consider it.

Kicking the can down the road isn't a policy. Nor is burying your head in the sand.

How to prevent bubbles

The new year sees the launch of the EU’s new financial supervisors: the European Banking Authority, the European Insurance and Occupational Pensions Authority and the European Securities and Markets Authority. If you haven't already done so, have a look at our take on the new EU supervisors here.

Green MEP Sven Giegold (Germany), who took the lead on the issue in the European Parliament, seems to be their most ardent supporter. He told German TV channel ARD that the huge structural problems in Ireland's banking sector "could have been prevented by the new European banking supervisors, thanks to their new legal possibilities".

Hmmm, a bit of a simplistic explanation, no?

Giegold doesn't have to look very far to spot the reason why his reasoning is painfully incomplete. In fact, casting his eyes to Frankfurt and the ECB would do the trick.

As often repeated nowadays, low eurozone interest rates, essentially designed for a sluggish Germany, led to an abundance of cheap credit in Ireland, in turn fuelling a property bubble that burst with the financial crisis in 2008, while the Irish government turned a blind eye. The Irish banks became insolvent, and private debt became public debt through bank bail-outs.

Inappropriate interest rates weren't the only issue, but to ignore the problems they caused Ireland is just silly. Therefore, there are several problems with Giegold's view:

1. It's heroic to assume that the EU's financial supervisors - somehow by virtue of being ran at the EU level as opposed to the national level - would spot the credit dangers looming, and act accordingly. It's also not clear why EU supervisors would be less vulnerable to commercial or political "hijack" than their national counterparts.

2. Regulators often find it difficult to spot bubbles, not matter where they sit (in the Spectator, Johan Norberg does a good job of breaking down the flawed assumptions underpinning the thuinking ahead of the 2008 crash). Ireland, for example, had been experiencing sound growth since the beginning of the nineties, thanks to some brave economic reforms. Booming house prices could be seen as 'normal' in such economic circumstances. It's not at all clear that the new EU supervisors would possess the kind of competence needed to really dig into the markets, or know where to look (American regulators quite clearly didn't pre-Lehman).

Having said that, however, in a best case scenario, the European Banking Authority, alongside the European Systemic Risk Board, could in theory serve as important facilitators of information sharing to help regulators/supervisors keep up with new developments, such as the rise of the shadow banking system, and control leverage accordingly. The EBA could also coordinate cases where cross-border banks expose taxpayers and savers in different countries to risks, ideally leading to wind downs of insolvent banks at the minimum cost, rather than more taxpayer-backed bail-outs (solving nothing).

3. But, and here's the thing, even if the EU supervisors were to spot, say, a housing bubble and stop it (through taxes at the national level and regulating the housing market, for example), the problem of excessive cheap credit, fuelled by low interest rates, would not be addressed. There are other things to spend your cash on apart from houses. If money is cheap, risk-taking is easy. And the more risks the greater the scope for bubbles.

The only effective way to stamp out excessive cheap credit in a boom is to make money more expensive, through higher interest rates. But here the familiar dilemma appears yet again: in a currency union it's impossible to tailor the interest rates like this, meaning that the EU supervisors can scream "bubble" all they want.

This is of course a difficult conclusion to reach if you have an ideological commitment to centralised decision making and a single currency for everyone...