The results of the stress tests might provide a temporary fillip to markets: for now, shareholders have not been diluted and there will be little, if any, transfer of risk from banks to sovereigns.
However, the credibility of the stress tests has been weakened by (i) the exclusion of sovereign exposures outside the trading book from the stress test, (ii) the use of a Tier 1 capital ratio target as opposed to core Tier 1, (iii) allowing banks to exhaust all cumulative provision loss reserves in the stress scenario and (iv) crediting banks with tax loss generated from the stress test, even though these can only be applied against future years of profitability.
The results of the stress test showed that just 7 out of 91 banks failed (5 Spanish banks and one each from Germany and Greece), the combined capital shortfall being €3.5bn. This might reassure investors about the health of large quoted banks, but it is unlikely to restore confidence in the smaller periphery banks: 34 out of the 40 least capitalised banks in the stress test are in the periphery (periphery stands for Italy, Spain, Portugal, Greece and Ireland).
The 'low' hurdles (in form of a 6% Tier 1 capital ratio target and allowing all credit loss reserves to be used) explain why Spain, for example, comes up with such low additional capital needs (totalling €1.8bn for 5 institutions). We remain of the view that a number closer to €50bn of additional capital for the Spanish banking system (i.e. recapitalising to a maximum extreme stress with high hurdles) is what is necessary to restore confidence given both balance sheet solvency risk on the asset side and structural over-reliance on wholesale funding.
The stress tests consider a sovereign stress, as opposed to an actual credit event. If a sovereign defaulted/restructured we would expect haircuts on a much larger scale than the stress tests envisage, coupled with very large losses on private sector exposures as asset prices collapse and the economy slides into a deep recession. The authorities have judged that the banks do not need to hold capital against this tail risk due to the creation of the EFSF (European Financial Stability Facility). But if market concerns about sovereign risk resurface we would expect confidence in the banking system to be tested again.
Stress tests are supposed to ask demanding questions of financial institutions, to examine whether they hold sufficient capital to withstand the losses they would incur in the worst case scenario. The risk that spooked the market in late spring which forced the authorities to conduct the stress test in the first place was the potential for a sovereign credit event to wipe out the capital of the European banking system. The stress tests did not seriously address this question: the sovereign stress was mild (applied to only those bonds held in the trading book) and banks were deemed to have passed the test so long as they scraped over a none-too-demanding tier 1 hurdle, even if all credit loss reserves had been exhausted and their balance sheets were awash with deferred tax assets.
It may not matter that this trillion euro question has been ducked in the near-term: the market appears to be less concerned about the potential for a sovereign credit event in the immediate future than it was a month ago, so funding conditions may continue to ease for the European banks. But if and when these fears resurface, the market will once again revisit the risks to the solvency of the European banks. It can learn nothing positive from this exercise apart from the fact that large European financial institutions are well positioned to face very adverse scenarios.
