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European bank stress tests have acquired a bad name. In 2010, they gave Irish banks a clean bill of health – just four months before the sector collapsed. In 2011, both Spain’s Bankia and Dutch SNS Reaal passed – only to implode. The 2014 test looks a little better – but is still far too soft.
The aim of a stress test is to reassure both regulators and investors that the banking system will not collapse if bad times lie ahead. That means assuming sufficiently tough conditions in the “adverse” scenario to allow for a worse than usual future. The test only partly achieves this.
Consider a few of the assumptions banks must make.
Greek bond yields return to where they were last summer. The Greek economy is the strongest – albeit still shrinking – since 2008. All of Europe falls into recession, but both Spain and Italy shrink less than last year, while the Dutch and Portuguese do the same or better than the last two years together.
Eurozone shares must be assumed to fall 18 per cent, something they did (or worse) at some point during 2008, 2009, 2010, 2011 and 2012. This should be the baseline assumption, not the worst case. Some parts of the test look tougher, if sometimes odd.
Recessions are assumed to be worse in the US and Japan than the eurozone, while the emerging world and eastern Europe have a dire time. Germany and France both see serious recessions for the first time in five years. Banks with big foreign operations, especially in eastern Europe, may find this hard.
But the tests are too easy to provide reassurance. Do the markets care? No. Investors no longer need reassurance about bank survival, and are happy that easy tests mean less chance of dilutive share issues. Investors have been busy re-rating Europe’s worst banks, with their shares rising far more than strong banks this year. Yesterday, the pattern continued, with every European bank rising, and some of the weakest rising the most. Less stress, more success.
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