EU Looks to US for Advice on Stress Tests

Bloomberg reported that the EU is looking to the US for advice on its stress tests so that the test will be seen by investors as credible.

European officials are taking advice from U.S. counterparts on how to improve their bank stress tests as they try to shore up their defenses against a debt crisis that has crippled the euro currency zone over the past year, according to Belgium's finance minister.

Didier Reynders said Tuesday that Europe has to organize "better" and more transparent stress tests than those conducted last summer. The results published in July came under a huge amount of criticism for giving the all-clear to a number of banks that have since been shown to need help, notably in Ireland. Many analysts dismissed them as nothing more than a whitewash.

"We need to organize the same kind of stress tests on both sides of the Atlantic Sea because if we don't have the same kind of stress tests as the U.S. and in Europe, we will have many criticisms of them," Reynders said ahead of a meeting of the EU's 27 finance ministers.

The problem with stress tests is that the results are determined by regulators before the fact and the market knows it.

For example, the US is conducting the current round of stress tests to 'show' that the too big to fail banks can start paying dividends again.  Most, if not all of these banks, will 'pass' the stress test.  In reality, none of these banks should pass the stress tests given their exposure to potential repurchases of mortgages sold to the agencies and private investors and the potential losses on second mortgages, commercial mortgages and toxic securities held on their balance sheet.

The comments come a day after ministers from the 17 euro nations discussed boosting the size and powers of the region's bailout fund as a way to help tame the market turmoil that has pushed Greece and Ireland to require rescues. While they indicated that final decisions on the matter would be taken over the coming months, the bloc is clearly trying to come up with a more comprehensive solution to its crisis.

Reynders said discussions about the stress tests are currently taking place between Michel Barnier, the EU's internal markets commissioner, and U.S. colleagues to organize similar stress tests.

While the European stress tests met a lukewarm response -- at best -- in the markets, the U.S. tests of 2009 were widely credited with helping to ease the financial crisis in the world's largest economy and limiting the length and depth of the recession.

Actually, it was not the stress test that helped to ease the financial crisis.  Rather, it was the commitment by the US Treasury to invest as much capital as it took to keep these 19 banks solvent.  The problem in Europe is that the size of the losses in the banking system is larger than the capacity of the governments to fund.

Ten of the 19 U.S. banks that were tested failed and were forced to raise nearly $75 billion to shore up their finances. In sharp contrast, only seven of 91 European banks tested failed and were required to raise a paltry euro3.5 billion.

The EU decided at the end of 2010 that it would have to do another round of stress tests this year following renewed concerns about Europe's banks as unease grew over the public finances of many countries.

The main reason why Ireland had to be bailed out to the tune of euro67.5 billion in November was that its public finances were saddled with banks' massive losses. The same banks got the all-clear last July from the little-known European regulator, the Committee of European Banking Supervisors.

The committee has since been replaced by the new European Banking Authority, which is currently working on the methodology of new tests, due to be published in mid-2011.

"The problem to my mind last time around was that there was a certain variety in the implementation in some member states," Monetary Affairs Commissioner Olli Rehn said late Monday.

That variety was necessary unless the stress test were to reveal that entire banking systems are insolvent for several European countries.

The stress tests' methodology and implementation will be discussed at the meeting of EU finance ministers, who continue to grapple with the debt crisis despite some easing in market tensions over the past week.

The 17 eurozone finance ministers also continued to discuss with EU counterparts outside the eurozone -- such as Britain and Sweden -- about ways to improve their handling of the crisis. In their meeting Monday, eurozone ministers looked at ways of increasing the powers and scope of the bailout fund and enacting further economic reforms in order to get past simple fire-fighting -- that is, to build market confidence preventively rather than keep rescuing countries in need.

German finance minister Wolfgang Schaeuble said it's important that the euro countries put "together a package that absolves us from the necessity to react again every couple of months."

In addition to the short-term measures, like the bailout fund, Schaeuble said the package needs to focus on solid economic policies and strengthening competitiveness as well as economic and fiscal coordination between eurozone countries.

The stress tests in Europe are a delicate balancing act.  On the one hand, there is the capacity without jeopardizing the solvency of individual countries to increase their debt to bailout their banks.  Added to this is the capacity of the bailout fund.  On the other hand, there is the need for capital by European banks.  The results of the stress test need to come close to, but not exceed the combined bailout capacity of the governments and fund on a country by country basis.

Even if the stress tests can achieve this, there is no guarantee that the market will not think it is a whitewash.  After all, the market is aware of the bailout capacity constraint and has not forgotten the experience with Ireland.