Monday, March 14, 2011

Highlight of Euro Stress Test II: Disclosure of Data

Reuters carried an article in which analysts said that the major positive they expected from the second round of European bank stress tests is the release of some bank data.  Analysts plan to use this data to run their own independent stress tests.

As regular readers of this blog know, this is exactly what the FDR Framework would predict would be the reaction of the market - give us the data and let us do our own homework.

The only question that is outstanding about the stress tests is how far short of full transparency they will fall.  We know that the regulators are not going to provide full transparency and release each bank's current asset-level data.  The question is will they release enough data so that the stress tests run by investors can actually provide useful information.
Investors hoping for clarity from this year's European stress tests can expect at best to be given enough data to run their own assessment. 
The problem is that the new regulator running the exercise is unable to challenge EU policy that simply will not accept any of its member countries could default, even theoretically. 
"They have to go for the second-best solution, which is giving transparency of banks' sovereign exposures so that investors can calculate the implications of this particular stress factor themselves," said Nicolas Veron, senior fellow at Bruegel, a Brussels-based think-tank. 
The aim of the tests is to restore confidence in the region's banking sector after last year's health check was widely criticised for lack of transparency and credibility. 
Only seven banks failed last year's tests and needed to raise just 3.5 billion euros, far less than expected. All of Ireland's banks passed, yet months later Dublin needed an 85 billion euro bailout and all its lenders had to be rescued. 
Though the 2011 exercise is being run by the new European Banking Authority (EBA), under pressure to prove its own credibility as a regulator, it will still be flawed by the same inability to force banks to show a loss on assets held in their long-term "banking book," where they park sovereign bonds.  
... "Provided you get the disclosures for the market to run its own stress tests I don't think it's a fatal problem that the banking book isn't stress tested," said Mike Harrison, analyst at Barclays Capital. 
...To run your own test, however, you need to know that the capital being tested across countries is of roughly the same quality, not an easy task without full transparency. 
Last year banks had to meet a Tier 1 capital requirement of 6 percent to pass. This refers to a broad measure of a bank's resilience to shocks, but lenders can pad it with lower quality assets which obscure exactly how much cash is available to tap. 
Analysts would have preferred to use a stricter 'core' Tier 1 benchmark comprising shareholders' capital and retained earnings, possibly with a 5 percent pass rate. That is opposed by some countries as it would make the test harder to pass. 
Germany, for example, wants to include the debt-equity hybrids known as "silent participations" commonly held by its banks, sources familiar with the matter have said. This form of capital has been criticised because it cannot absorb losses while the bank is still in business. 
The solution could be to stick with Tier 1 capital, but include a detailed breakdown of what it contains. 
Another proposed improvement is to highlight the banks that nearly miss the stress tests requirements, in order to pressure them to recapitalise. 
The test also looks set to apply higher funding costs and greater losses from a fall in property prices. It should also ensure that economic stress scenarios are consistently applied under similar accounting rules. 
Regulators are also sticking their necks out politically by insisting that governments have a plan in place to top up capital at banks that fail, unlike last year. 
Germany, in particular, needs to show how it would recapitalise its landesbanks, critics say. 
... Regulators say greater transparency means investors and analysts can run their own tests or add elements if they don't think the EBA is being tough enough. 

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