European Banking Authority deserves our thanks

I would like to take this opportunity to thank the European Banking Authority for reminding governments and financial regulators around the world about what restores confidence in the capital markets.

It is not regulators disclosing the results of stress tests.

Rather, it is disclosure of all the useful, relevant information in an appropriate, timely manner so that market participants can analyze this data and adjust the pricing and amount of their exposures based on risk.

While the disclosure of data that accompanied the stress tests fails to meet either the "all the useful, relevant information" or "in an appropriate, timely manner" criteria, it was dramatically better than the black hole of opacity that previously existed.

As reported in an article in the Telegraph,

... [T]he EBA and the European Union are under the impression that their power to pass and fail banks will translate directly into making them better at what they do. 

The fallacy of this approach is ... obvious... 

Namely that the regulators are setting themselves up for losing their credibility if the results of the stress tests can be discredited.  It is a no win situation for regulators.

Your humble blogger has repeatedly recommended that regulators should disclose the data and then survey market participants to see what the market participants think.  The regulators should then compare what market participants think and see if and why this differs from what the regulators' own analysis shows.

Take one of the more pertinent “stressed” assumptions the European authorities have used to test the 90 banks in the latest tests. 

Greek bonds are currently trading in the market at half their face value, yet the EBA seriously asks sophisticated investors to believe that they have properly tested the banks by applying a “haircut” of just 15pc to Greek debt. 

Or look at the €2.5bn (£2.2bn) of new capital the EBA says the eight banks that failed the tests will have to raise. 

Analysts at Credit Suisse, just three hours and 25 minutes after the EBA announced its results, have concluded that the actual amount needed would be more like €45bn and that 14 banks should have failed.  

The following part of the article is a description of the FDR Framework in action.  The EBA has provided disclosure and market participants are responding by analyzing this disclosure with the intent of adjusting the price and amount of their exposure to different European banks based on the riskiness of the individual banks.

As you read this, across the City and in financial centres around the world, groups of analysts at investment banks, hedge funds, pension funds, large companies and a host of other institutions are examining in detail the EBA numbers and conducting their own stress tests.  

They are likely to conclude that many European banks are in far worse shape than the authorities would like to believe. 

“Pass” or “fail”, the money men will make up their own minds about which banks are solid and which are not. 

Under their control are the purse strings every bank, large or small, requires to keep their doors open. 

Lose the faith of the funding markets and your days are numbered – as Lehman Brothers and Royal Bank of Scotland can attest. 

Some banks and their regulators may like to believe ... that the authorities’ stamp of approval is all they need to stay on the road. The financial markets are likely to take a different view. 

This week the markets will deliver their verdict on what they think the stress tests meant. They may, like Mr Enria, believe they were “rigorous”, “robust” and all those other fine words he used to describe them. 

More likely, Monday could see the beginning of a process that will deliver a much more real and painful test of the European banking system, one that will prove far more testing than anything the EBA chose, or was allowed, to inflict.