George Kerevan: Joined-up thinking is essential for eurozone's future

Published on Monday 17 January 2011 21:52

How do you "stress test" a bank to ensure it can weather future storms - say, a sovereign default which would wipe out the value of bonds held on the bank's ledger?

This is the conundrum which eurozone finance ministers were grappling with yesterday as part of their deliberations on how to create a permanent mechanism for bailing out member states in financial trouble.

At first sight, designing a stress test should be fairly easy. You look at a bank's portfolio and pick out the assets that are potentially non-performing. For instance, sovereign bonds on which the Greek government might default. Or Irish government bonds which might eventually need to take a "haircut". Then you see if the bank has sufficient capital to cover these losses. If it doesn't, you tell it to raise its reserve ratio.

Put this way, the dilemma facing the eurozone finance ministers is obvious. They require new stress tests to determine how much more Europe might need to set aside to help Greece, Ireland and Spain. But any official test that assumes - even hypothetically - the possibility of a Greek default, or the restructuring of EU sovereign debt, could spook the markets. Investors might rush to dump bonds, forcing up yields.

We've been here before. Last year the EU ordered stress tests as a quid pro quo for allowing member states to bail out banks in difficulty. Some 91 banks were tested in 20 countries. Curiously, only seven failed; i.e. were found to have insufficient reserves to cover potential losses. These seven were ordered to raise their capital by a (modest) total of €3.5 billion (3bn). The truth is that last year's tests were too easy to pass. For instance, Allied Irish Banks passed yet it still had to be bailed out later in the year. In contrast, the US authorities tested 19 American banks, ten of which were deemed to have failed and ordered to raise $75bn (47bn) in new capital.

The 2010 stress tests were rigged to avoid exacerbating the eurozone's sovereign debt crisis. In listing wobbly assets, they artfully discounted any sovereign bonds "held to maturity" on bank ledgers. The ostensible explanation was that such bonds, being long term, could be ignored as the current economic crisis would be of short duration. Thus a lot of potentially non-performing assets were quietly forgotten about.

In addition, six of the 14 German banks tested refused to disclose their exposure to sovereign debt. They included Deutsche Bank, Postbank, Landesbank Berlin, and the mutuals DZ and WGZ.

It would be wrong to say last year's tests were futile. They did lead to greater bank transparency which helped calm investor nerves.Deutsche and the other German banks were eventually forced to reveal their full sovereign debt commitments after share prices came under pressure However, analysts reckon that 24 of the 91 banks would have failed if their entire sovereign debt holdings had been included in the test - implying a capital shortfall of €15bn.

Fresh stress tests are being organised by the new European Banking Authority (EBA), which came into being this month. The regulatory agency, which has its HQ in London, has autonomy but there remains a lively debate in Brussels as to how the tests should be conducted.

One problem in stress testing concerns how to account for the high level of public support already being given to Europe's banks. Irish banks, none of which failed the last tests, have received over €50bn in liquidity support from their central bank.

The EBA is committed to a new "short-term" liquidity test, separate from any assessment of the vulnerability of bank assets; i.e. does the bank have access to ready cash to forestall a run. But in measuring liquidity, do you include the existing level of central bank support or do you test banks for how they would fare on their own? Many Irish, Greek, Spanish and perhaps a few German banks would fail a liquidity test if it did not include existing support from the European Central Bank.

It seems unlikely any fresh stress tests can avoid including all sovereign debt held by banks, or they will forfeit credibility. If so, the only way to avoid the bond markets taking fright next June, when the results are published, is to begin restructuring Greek debt now. Or we risk having the sovereign debt crisis combine with another banking meltdown. It is time the eurozone members stopped thinking they can deal with each problem separately, or piecemeal.

• George Kerevan is an SNP list candidate for the Lothians in May's Scottish Parliament elections.