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Banking tests do nothing but stress out markets

2010-07-08 10:45

Another week, another bad idea. With the markets still jumpy about Greece, the sovereign-debt crisis and the banking system, the European Union's leaders have come up with a way to reassure us that everything is just fine in the euro area, and there is really nothing to worry about.

They are called stress tests.

Banking tests do nothing but stress out markets

Regulators will take a hard look at the big European lenders, such as Banco Santander SA, BNP Paribas SA and Deutsche Bank AG, then run various catastrophic scenarios past them, and check that the bank has the strength to withstand whatever storms might blow their way.

Sounds like a good idea? Well, not really. In truth, there aren't any common standards, we don't know what scenarios are being tested, and we don't know if all the results are going to be published. All this is doing is sparking another round of feverish speculation.

In effect, it is the stress tests themselves that are stressing out the markets.

The tests probably sounded sensible when they were announced at an EU summit on June 17. The Bank of Spain said it would publish the results of its own tests before German Chancellor Angela Merkel and French President Nicolas Sarkozy followed suit, proposing assessments for all main European banks. "What's important right now is that we have maximum transparency," said Merkel, announcing the initiative.

There is absolutely no sign the tests - which are due to be published later this month - have calmed investors. If anything, they are more nervous about the fragility of the European banking system than ever.

Of course, it is possible to see what Merkel and Sarkozy were hoping to achieve.

Right now, speculators are having a field day. All they have to do is put out the idea that a Spanish savings bank or one of the German Landesbanken has a balance sheet stuffed full of dodgy loans. Then the markets dive. Since no one really knows what bank had lent money to whom, there is space for all kinds of wild rumors to flourish.

Disclose everything, and you reassure the markets that Europe's financial system isn't bust.

Good enough in theory. But there are five reasons why it isn't working out the way they hoped.

One, there aren't any common standards. European banks are all regulated on a national basis. The judgments applied to a Portuguese bank may be quite different to a Swedish one. Europe-wide stress tests don't make any sense unless there is a single European regulator applying the same standard to each.

Two, what's being tested exactly? There are all sorts of scenarios you can think of where the banks come through OK. A mild recession in Germany, for example. The oil price surging back to $100 a barrel? But what the markets are really nervous about is that Greece defaults, or Spain comes under attack, and that it brings down some really big banks. Unless you test the ability to withstand that kind of extreme event, it's just a whitewash, and that won't reassure anyone.

Three, it still isn't clear whether the results will be made public. Some of the German banks are resisting compulsory publication. The British regulators may not be allowed to release the results without the permission of the bank involved. Why should they agree to that when there might be sensitive commercial information being disclosed? And yet, if the tests are kept secret, it is just a joke. And investors will assume any bank that doesn't publish the results has something to hide.

Fourth, who says the horrors are hidden inside the big banks? If you know you have lots of bad loans, and you are about to be stress-tested, maybe you could offload them to a friendly hedge fund for a few weeks. You might be able to, or you might not. The point is, a speculator can always spread rumors that you have parked all the stuff somewhere else - and then the stress tests will have achieved precisely nothing.

Finally, and most importantly, it just sets off a new round of speculation. Now everyone is worrying about what the stress tests will reveal. It sets a deadline, and everyone is nervous about that. If you are going to have stress tests, get them done behind the scenes, then announce the results when you inform the public of the decision to have the tests.

EU leaders think this is a crisis caused by financial markets. They imagine a basically sound system is being undermined by a bunch of badly behaved traders and hedge-fund managers. And they think, naively, that if they just get enough information out there, everyone will see that the euro is in good shape, and stop worrying about it.

It isn't true. The real issue is that Greece is probably bust, will default sooner or later, and will inflict huge losses on the banking system when it does.

Stress tests won't change that harsh reality. All they are doing is making the markets even more nervous than before.

Matthew Lynn is a Bloomberg News columnist. The opinions expressed are his own.


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