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the results of the liquidity checks (which will not be part of the stress tests but of separate risk assessments) "will not be published".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.