Real value of European stress tests lies in disclosure

A David Enrich article in the Wall Street Journal discussed how the European Banking Authority saw the real value of the stress tests lying in disclosure.

As previously discussed, the disclosure did not go far enough.

The WSJ article makes the case for why current asset and liability-level disclosure is needed by focusing on loans that banks have made to countries experience sovereign debt problems.  Without knowing how the individual loans are performing or are collateralized, market participants are left to make worse case assumptions about the value of the loans given the sovereign debt problems.

Europe's banks are sitting on vast quantities of loans to individuals and businesses in cash-strapped Southern European countries, highlighting how plain-vanilla loans, not just government debt, pose potential risks to the Continent's troubled banking system. 

The holdings are detailed in disclosures Europe's largest banks made as part of the European Union "stress tests," whose results were announced Friday...

But officials with the European Banking Authority, the regulator that conducted the tests, argue that the real value of the exercise is the mountains of data—about 3,200 pieces—each bank was required to reveal about its balance sheet. That includes detailed, country-by-country breakdowns of the types of loans and securities on their books. 

During Europe's 15-month financial crisis, investor and analyst fears have centered largely on banks' holdings of sovereign debt issued by governments in financially shaky countries such as Greece, Ireland and Portugal. If those countries were to default, it could saddle banks and other holders of their bonds with big losses. 

But Friday's test results shed light on another potential problem for Europe's banks: huge piles of residential mortgages, small-business loans, corporate debt and commercial real-estate loans to institutions and individuals from ailing countries. As those economies struggle, the odds of rising defaults grow. 

Banks tend to be holding far greater quantities of those commercial and retail loans than they are of sovereign debt, according to a Wall Street Journal analysis of disclosures accompanying the stress tests. 

This year's stress tests represent the first time there has been a uniform way to measure this exposure. Until now, banks have disclosed their portfolios of loans to customers in troubled countries on a piecemeal basis. That made it virtually impossible to aggregate data across the industry or to compare different institutions. 

"The country-by-country exposure [data] is better than any data we've seen before," said Alastair Ryan, a London-based banking analyst with UBS AG. "It's giving me more things to be fearful of," Mr. Ryan added, referring to the disclosures of some banks' large holdings of loans to customers in troubled countries...

The stress-test figures actually understate some banks' holdings of loans in certain troubled countries. That is because the European Banking Authority required banks to disclose their loan holdings in countries only if they represent more than 5% of the bank's total loan exposures. 

As a result, some banks opted not to disclose details of their loan portfolios.