Tuesday, June 21, 2011

EU stress tests confirm regulators addiction to creating financial instability [update]

Had the article on the current round of EU stress tests not appeared in Reuters, I would never have believed it.  Unfortunately, there is the Reuters' article quoting from EU Economic and Monetary Affairs Officer Olli Rehn.
"In the agreed methodology of the stress tests, the capital requirements were in fact tightened, and many other improvements were made," Rehn told a news briefing after a meeting of EU finance ministers. 
"In this context it was a deliberate choice that we will not assume a default of any euro area or any EU member state and of course that's linked to our policy, because we do not believe restructuring is good for Greece or other countries. 
"We have decided today that we are engaged in a Vienna-style initiative on a voluntary basis, which will avoid a credit default, which does not mean debt restructuring and we do not envisage default as a scenario," Rehn added.
I had to re-read the highlighted text as it confirms that this round of stress tests is designed to be no more credible than the last round.

I can understand why the EU would prefer that Greece not restructure its debt.  However, the whole point of stress tests is to find out what the impact might be if this were to occur.

By not knowing what the impact might be, regulators are not constrained in their statements about how Greece would be Europe's Lehman Brothers.

It is the choice by regulators to not know a knowable fact and then issue armageddon type statements that directly contributes to financial instability by highlighting the fact that the market does not know which banks are solvent and which banks are not solvent.

Barclays and Standard Charter have greatly reduced their unsecured lending exposure to eurozone banks as a result of not knowing who is solvent and who is not.  Activity like this greatly increases financial instability.

Compare this to what would happen under the FDR Framework.  Under the FDR Framework, all market participants would have access to the useful, relevant current asset and liability-level data in an appropriate, timely manner.

With this data, market participants could run for themselves or hire third party experts to run for them stress tests.  They could choose to look at a Greece restructuring.  As a result, they could change the pricing and amount of their exposure based not on fear, but facts.

Since the original post, the EU has changed its mind or including a restructuring of Greece in the stress tests.  According to an article on Reuters,
Europe's banks have been told to put a figure on potential losses from holdings in Greek and other sovereign debt to ensure a health check of lenders realistically reflects the deepening euro zone crisis. 
Sources involved in the European Union stress test of 91 banks said regulators are "tightening the thumb screws" on lenders to spell out the impact of a government debt default -- but without having to make the politically unacceptable assumption in the test that a default can happen. 
... Until now fallout from the sovereign debt crisis was focused on a bank's day-to-day trading book but most government bonds are held on a bank's core banking book. 
The disconnect has become even starker as sovereign woes get worse, giving regulators a bigger headache as they try to avoid another stress test flop. 
"Banking books are being stressed much more harshly than last year and than in the original draft of this year's stress test. That will help increase the credibility of the tests," an official in charge of the stress test at his bank said. 
"That will result in factually putting countries like Greece on default status," the official added. 
The test is aimed at shoring up investor confidence in the sector which is already being hit by the prospect of tougher regulation eating away into profitability. 
After last year's test flopped -- Irish banks had to be bailed out after passing -- the fledgling European Banking Authority (EBA) which is conducting the health check, is staking its reputation on delivering a credible exercise this time round. 
Europe has raised the bar for banks this year, demanding they hold more, better-quality capital to withstand a possible 2-year recession. They have to hold more than 5 percent of core Tier 1 capital to pass the exam, or raise capital. 
A German regulatory source said the EBA had tightened the screws to draw up the "harshest version" of haircuts or losses on government debt. 
... The EBA's tougher approach looks at how a bank would survive a four-notch rating downgrade to low rated government debt holdings -- a move that would take Greek bonds into default territory. 
Germany's Landesbanks are seen as among the weaker lenders in Europe but are still expected to pass despite a toughening up of the banking book rules. 
"We still assume that the Landesbanks will pass the EBA stress tests," a spokesman for the Association of German Public Sector Banks said. 
More data on banking book fallout from the euro zone crisis will also help the EBA fulfil another aim -- giving markets enough detail so they can conduct their own tests to include scenarios such as the impact of government defaults.
If the EBA really wanted to give markets enough detail so they can conduct their own tests, they would release the current asset and liability-level data for each bank. 

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