Saturday, October 1, 2011

How bad is the situation in Europe? Germany would like to know!

As we come to the end of a work week, I found myself reflecting on three interesting data points concerning the European financial crisis.
  • Less than 3 months ago, the European financial regulators suggested that as a result of the latest round of stress tests, European banks needed to raise less than 10 billion euros in new capital.
  • Less than 2 months ago, the IMF suggested that European banks needed to raise between 200 and 300 billion euros of new capital.
  • Less than 1 month ago, US Treasury Secretary Tim Geithner suggested that between European banks and at-risk sovereigns, there was a need to raise 2 trillion euros.
Admittedly, the European financial regulators did not consider a sovereign default in their stress tests, so their estimate of how much capital is needed is probably too small.

However, and this is a big however, their estimate is the closest of the three estimates to being constrained by what is actually happening at the banks.  The stress tests were run on some of the banks' assets and liabilities.

Unless the results of the stress tests are completely fictional, the tests suggest that European banks have the capacity to absorb a significant amount of write-downs without requiring governments or the European Financial Stability Fund to recapitalize them.

The economists at the IMF estimated capital needs based on what they thought were the most likely levels of write-downs as a result of sovereign debt restructuring.  

Admittedly, the IMF economists did not know the extent to which sovereign debt positions might be hedged so capital needs could be lower if banks had hedged their positions.

Again, we have an estimate of capital needs that suggests that Europe can handle the problem with in its current plans.

Finally, we have Mr. Geithner's estimate.

Admittedly, it includes funding for sovereign bailouts.  However, it strains credibility to believe that it includes the European financial regulators' estimate of capital needed by the banks and not the IMF's.

If the IMF and Mr. Geithner's estimate is right, it suggests that European policy makers and financial regulators have seriously misled market participants.  Is that true of all European policy makers and financial regulators?  Is it possible that Germany's policy makers and financial regulators did not mislead market participants?

Given the US experience with stress tests, I am not naive enough to believe that the results of the tests provided to the public did not understate the amount of capital the tests actually found was needed.  I just do not believe that the financial regulators would release numbers that are off by a factor of 10.  It is far too likely that the market will quickly discover the shortfall and the resultant loss in the financial regulators' credibility will fuel the fear of just how bad shape the global financial system is in.

What Germans would like to know is which of these three estimates is right! 

There is only one way to find out and that is disclosure of each bank's current asset and liability-level data.  Market participants can analyze this data and assess how much, if any, capital each bank needs. 

No comments: