Crunch week for Europe as new bank stress tests to be unveiled

Here’s a personal snippet. I have never failed an academic exam in my life. Failed a driving test and separately, a motorcycle test, though, each only once before passing the second time. But academically the record is 100%. I came very close once to failing a tax exam. It was not a subject I took to and it was never going to be central to my career, and the rules, laws, exceptions and even principles were very difficult for me to absorb. And on the day of the exam itself, I sat through the three hours and threw as much information at the answers as possible, hoping something would stick. Truth was, I didn’t understand the subject to the level required. It was one of four subjects examined over a couple of days and I had to wait three months to get the results. And on the day the results came out (by post – the internet was only in its infancy) – I picked the letter up from the door mat on the way out to work, didn’t open it because I feared the worst and it was only on the train platform waiting for the train that I summoned up the courage to grasp the nettle. And thinking about it now, opening exam results on a train platform is probably a very bad idea. But open it I did and looked down for the four subjects and four grades and looked for the “D” that would have indicated failure. It wasn’t there and it took seconds to grasp that I had gotten a “C” in tax, just enough to pass. And I could not believe it. It was a mistake surely. A few days after the exam results came out, the institution published its examiners’ report which reviewed overall the performance of all candidates, and I will forever remember the review of the tax exam – the standard demonstrated by students was abysmal, questions were unanswered, candidates gave a number of options for the answers and one just wrote a poem and left it at that! And the reason I deduced I had passed was that the institution apparently had a quota for passes -35-40% of candidates at that level and they adjusted the pass mark, up or down, to force the final result. And that’s how I passed taxation. Pretty grubby, when you think about it really.

But the episode is recalled now that the Europe is yet again to publish on Friday next, 15th July 2011, the results of stress tests on the main banks in Europe. Only two weeks ago, Reuters was reporting that the results would be published on Wednesday 13th July, but maybe those in charge concluded that mightn’t have been a good omen. It’s a pretty important event and there is quite a strict timetable for the release of information next Friday, as set out in the announcement here, by the body supervising the stress tests, the European Banking Authority (EBA). I wouldn’t blame you for glazing over at this point and ask who the hell the European Banking Authority is. It is the replacement body formed only eight months ago to take over the work of the Committee of European Banking Supervisors (CEBS). And again you ask, who the hell is/was the CEBS. The CEBS produced the first stress tests in July 2010, remember those? 91 banks were stress tested and seven failed, five of which were Spanish. And two Irish banks were tested, AIB and Bank of Ireland and both passed. And only a few months later, it was established that both banks needed €18.5bn to stay open. The total new capital requirement for banks assessed by CEBS last year was €3.5bn for all 91 banks.

Of course last July 2010, there was widespread derision of the results of the stress tests. A recurring criticism was that the stress tests did not take account of a default by a country in the EU which might then render worthless or less valuable bonds held by the subject banks. That is being remedied in these present stress tests, but already suspicion is understandably growing about how rigorous the stress tests will be. Reuters reported on 28th June 2011 that it has been pre-determined that 10-15 of the 91 banks were set to fail. Citing a “source”, Reuters wrote

“The EBA wants the number of banks that do not pass the tests to be around that level [10-15] to show the examinations were serious, said a second source, adding the authority did not want to push for more, for fear it could spark panic.

“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,” said the source. “A number in the teens is about right.”

Bloomberg also (separately) reported “The EBA may fail as many as 15 banks to give the lender examinations more credibility, a person familiar with the negotiations told Bloomberg News.”  This was subsequently denied by the EBA but given the fiasco of last year’s results, who would you believe?

Moody’s, the bete noire ratings agency – at least to Europeans after it downgraded Portugal’s credit status to junk during the week – is reported to have concluded that 26 out of the 91 banks will need additional capital support. The list of 26 shown here at zerohedge shows all three Irish banks needing more capital and shows six Spanish banks needing more capital. Moody’s are reported to have assessed the additional capital requirements of Spanish banks at €45-119bn. The view on here, which is based on very rough estimates of current loans and provisions, is that Spanish banks will need considerably more. Remember Spanish banks are understood to have €450bn of land and development loans which in Ireland required 60% write-downs when transferred to NAMA. Spain is understood to have 10% provisions for losses, meaning that if Spain’s property market were to go the way of Ireland’s, an additional €225bn of losses might be crystallized. Spain has so far weathered the property bust with only a 21% decline in residential prices from peak – compared to 41% in Ireland – but in Q1,2011 alone the decline in Spain was 4.7%, and take a look at the adverse scenario for 2011 for residential property for Spain above, minus 12.3% – that is looking low based on Q1,2011 results. So the results this week will be closely watched and may finally herald a conclusion toSpain’s pretendy bank health, which might in turn lead to a wider EU solution to over-indebted countries includingIreland.

And lastly, remember that most of the old CEBS board members who oversaw the widely discredited stress tests last year are now board members of the EBA. How safe will the stress tests results on Friday be? About as safe as a pillion passenger on my motorbike when I first took my test.

Stress tests 2011 – key documents and links

EBA announcement of stress tests – 18th March, 2011 here

EBA announcement of timetable for release of results of stress tests on Friday 15th July, 2011 is here

List of 91 banks being subjected to stress testing is here, and includes three from Ireland – AIB, Bank of Ireland and Irish Life and Permanent – and a staggering 25 from Spain including Santander, Bilbao, Popular and BBK.

The EBA methodology used in carrying out the stress tests is here

A 3-page European overview of the interest rate, unemployment, GDP and inflation assumptions is here

A 4-page European overview of the so-called adverse scenario is here

A 2-page summary of the baseline and adverse scenario by country showing GDP, unemployment, interest rates, exchange rates, inflation, commercial and residential property prices is here.

Approach adopted in stress testing to recognise losses on sovereign bonds is here.

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