The European Banking Authority (EBA) continues to court controversy with the way it is administering the recent round of bank “stress” tests. The testing process has been in progress since March and is designed to restore confidence in the European banking system awash in questionable sovereign debt.
As part of the evaluation, the banks have been provided with a formula that will “address inconsistencies and excessive optimism” when it comes to assessing risk of these sovereign exposures. Based on the risk assumption, the banks can then determine the extent of the “haircut” to which they could face and then determine how much they need in reserves to cover the potential losses.
What the EBA is not doing, however, is to force the banks to simulate the impact of an actual default or debt restructuring. If the EBA is hoping to restore confidence with this approach, it leave much to be desired. Especially given the track record of the previous round of stress testing.
Last year’s stress test results were called into question from the very beginning simply because so few banks were deemed at risk. Indeed, the Irish banks were given a clean bill of health just months before the Irish government was forced to provide emergency funding to keep them afloat.
Nevertheless, the EBA claims that owing to the improvements introduced this year, the results will provide a truer picture of the state of the financial system. Still, they are not addressing the greatest fear of all investors – an out-and-out default by a sovereign nation.
Testing Results Leaked
A story carried by several news agencies Tuesday morning quoted an anonymous Eurozone insider as saying that potentially one in six of the ninety-one banks tested will fail the testing process. This means up to fifteen banks are deemed at risk based on the criteria imposed by the EBA.
On the surface this appears to be a dreadful result but according to the EBA source, this is exactly what the banking authority wants as it feels this will prove that the EBA is serious in its assessment.
“In order to demonstrate that it is credible, the EBA would need to show that the number of bank failures is significant, without being substantial,” the source was quoted as saying. “A number in the teens is about right.”
The process still has the appearance of being manipulated given the nature of the comments, but in light of last year’s fiasco, there could be a degree of method in the madness. Besides, no one is buying the old “the banks are all right line” line any how, so by finding a significant number as being at risk – but not too many – this may actually show investors that authorities are indeed serious this time.
Final results are due in a couple of weeks at which point we’ll see once and for all how the EBA intends to deal with the bank solvency question.