Did banks adopt the FDR Framework model of bank supervision?

The Financial Times ran an article on the Institute of International Finance, a lobbying organization of some of the largest financial institutions in the world, in which the IIF indicated that banks are willing to accept effective regulation.

The IIF defined effective regulation not as rules based but instead as combining the provision of all the useful, relevant data by the banks with the ability of the party that receives the data to transform it into information for promoting financial stability.

As regular readers know, market participants like competitors and credit and equity market analysts are better at transforming this data into information than the regulators (a point that regulators like the Bank of England's Andrew Haldane and the Irish Central Bank's Patrick Honohan have made).

As regular readers know, market participants like competitors and investors can provide a significant assist to regulators in promoting financial stability.  Market participants promote financial stability through the exercise of market discipline.

Market discipline takes the form of market participants adjusting the price and amount of their exposure to any bank based on its current risk profile.  Market discipline applies brakes to bank's risk taking by increasing a bank's cost of funds and the lower its access to funds as it becomes riskier.  Market discipline encourages banks to reduce their risk profile by lowering a bank's cost of funds and increasing its access to funds as it becomes less risky.

What the IIF says it wants as effective regulation is exactly what is provided under the FDR Framework.

Tougher supervision of banks is critical to financial stability but could easily descend into box-ticking and laundry lists of new rules that will do little good, a global banking industry group has warned. 

The Institute of International Finance, which represents 400 groups in 70 countries, said in a report issued on Tuesday that its members support and are willing to pay more for tougher oversight by experienced regulators. In the wake of the financial crisis, the group also said it accepted the duty of regulators to challenge risky business models and impose additional capital and control requirements where necessary. 

“Well-run firms have every reason to welcome strong and effective supervision . . . Regulation alone cannot create a safer financial system — good regulation must to be matched by improved industry practices and stronger supervisory systems,” said Peter Sands, chief executive of Standard Chartered and chairman of the IIF’s special committee on effective regulation.

As everyone knows the strongest and most effective supervision is when all market participants have access to the curent asset and liability-level data.  Those market participants with a financial exposure to the banks, this includes the regulators who have a financial exposure through deposit guarantees, have a strong incentive to analyze this data and to adjust both the price and amount of this exposure based on what the analysis shows is the riskiness of the banks.

But the IIF warned that the supervisory process could become unnecessarily contentious and rule-based. 

“There is a significant risk that increased activity and the imposition of more requirements will themselves be mistaken for more effective supervision,” the report said. “Supervision should not be about shadow-running firms or second-guessing all decisions.” 

Financial groups have a role to play in improving supervision as well, the IIF said. Not only must they provide relevant data, but groups should be open with their regulators about their risks and challenges and interact with authorities on a “no surprises” basis. 

“Banks should be fully transparent and give the supervisors the information they need,” said Kerstin af Jochnick, who chaired the IIF committee behind the report. “If you have good supervision you can rely on your counterparties in the market.”

When the supervisors include all the market participants, the IIF is embracing the FDR Framework.

It is a very important point that when a bank has the current asset and liability-level data on its counter-parties, the bank can rely on these counter-parties (the bank will not do business with a counter-party that poses an unacceptable risk).

The IIF, which tends to be dominated by the very largest banks, also warned against creating a special supervisory regime for global groups. The Financial Stability Board, a worldwide regulatory body, is due to consider additional capital requirements for the largest, systemically important banks later this year. 

“There is no case for adopting fundamentally different approaches to groups of firms that may be judged to be systemic,” the report said.

When all financial firms have to disclose their current asset and liability-level data, there is no reason for different approaches to groups of firms.  Market discipline will act to reduce the risk of the very largest banks.

The group also said the banking industry would prefer to pay a higher levy for more and better regulators to a more general tax on financial activities.

The higher levy is the cost of making their curent asset and liability-level data available to all market participants in an appropriate, timely manner.

Fed shows that liquidity toolbox cannot solve solvency crisis

As predicted under the FDR Framework, the only cure for a solvency crisis is disclosure.  This was confirmed by an article in the Wall Street Journal that discussed how the Fed has run out of tools in its liquidity toolbox to restore functioning lending and capital markets.

To regular readers it is no surprise that liquidity did not solve the problem.  The lesson learned from the credit crisis by both lenders and investors was not to blindly chase yield when the Fed keeps interest rates down.  $4 trillion in losses tends to concentrate the mind even when the Fed pursues zero interest rate policies.

Ultimately, if lenders are going to lend or investors are going to invest, they need to be able to access all the useful, relevant information in an appropriate timely basis so that they can analyze this information and adjust the price and amount of their exposure to reflect risk.

Without disclosure, lenders are reluctant to lend and investors are reluctant to invest.

Or as Yves Smith said it so nicely in a post on NakedCapitalism,

Making money cheaper is not going to make anyone want to take risk if they think the fundamental outlook is poor. Except for finance-intensive firms (which for the most part is limited to financial services industry incumbents), the cost of money is usually not the driver in business decisions, Market potential, the absolute level of commitment required, competitor dynamics and so on are what drive the decision; funding cost might be a brake. So the idea that making financing cheaper in and of itself is going to spur business activity is dubious, and it has been borne out in this crisis.

The only way to get the global economy going again is the restoration of confidence and the only way to do that is through the provision of disclosure.

Minutes from the Fed's last meeting, released Tuesday, seem to leave the door open to further extraordinary actions by the central bank should the economy continue to weaken... 

[J]ust what exactly could—and should—the Fed do at this point? Its target lending rate is already parked at zero. The Fed just completed a second round of buying government bonds in hope of providing additional stimulus to the economy. 

And the punch bowl isn't totally empty: the Federal Reserve continues buying Treasurys to keep the size of its balance sheet steady rather than allowing it to contract as mortgage holdings mature. 

Yet the results of these extraordinary efforts have been mixed. Deflation fears might have receded but were replaced by a spike in food and gasoline prices that has also undermined domestic growth. Meanwhile, the unemployment rate has actually risen of late, to 9.2% in June from 8.8% in March....

The reality is that the Fed simply doesn't at this point seem to have the right set of tools to fix what ails the U.S. economy. Even though interest rates have been pushed to historically low levels, demand for loans remains tepid. Other measures, such as lowering the 0.25% rate the Fed pays banks on their excess reserves, aren't likely to spur much activity. 

"The well looks dry," says Credit Suisse equity strategist Douglas Cliggott. 

Further efforts by the Fed to manipulate economic behavior and markets aren't likely to be effective, he added. 

In absence of disclosure, European banks run for hills

Don't look now, but there is the modern day equivalent of a bank run going on in Europe.  As reported in a Wall Street Journal article, European banks are reducing their exposures to any bank or sovereign where there is concern about its solvency.

Regular readers know that bank runs occur in the absence of disclosure.  There is a change in belief about the bank's solvency.  When this occurs, investors and depositors have an incentive to get their money back before the bank collapses.

At a minimum, as predicted under the FDR Framework, the lack of disclosure is leading to a freezing of the interbank loan market.

Some of Europe's biggest banks are taking steps to shore up their defenses should the debt crisis spiral out of control and one or more countries leave the euro zone, a sign of the financial sector's increasing worries over the continent's plight. 

Some banks recently have been reining in some cross-border lending to companies in countries like Spain and Italy, bank officials say. Others are parking more money with the European Central Bank, according to ECB data. Banks also are increasing their use of credit-default swaps as protection against their holdings of sovereign debt from shaky countries. 

As the crisis deepens, even European central banks are considering the possibility that one or more countries could leave the currency bloc, according to people familiar with the matter, a scenario that until a week ago seemed to many as implausible. 

Overall, European banks appear to be growing increasingly wary of lending to each other, even on a short-term basis. Deposits parked at the European Central Bank's overnight deposit facility jumped Tuesday to €90.5 billion ($127 billion), up from €65.7 billion a day earlier. The last time the ECB's deposit facility was so flush was more than five months ago, on Feb. 7, when banks stashed €137 billion there. 

While the amount of funds parked in the ECB facility ebbs and flows over the course of each month for technical reasons, it has historically been a good proxy for how fearful banks are about lending to each other—and about the financial crisis intensifying. 

The moves reflect mounting concern that Europe's political leaders lack the will to adequately address the Continent's problems. The worries have shifted from concerns that Greece may default on its debts to a more dramatic scenario where Greece or another country departs the currency bloc. 

Although the European debt crisis has been dragging on for roughly a year and a half, it appears to have entered a new, more perilous, stage this week. Expectations have faded that European officials will be able once again contain Greece's problems and avoid a destabilizing default that would inflict losses on banks holding Greek debt. 

In the process, the spotlight has turned back to Italy and Spain's debt problems. Earlier in the year it had become conventional wisdom that despite economic and fiscal problems of their own, those countries had been walled off from Greece's woes. But the recent focus on Italy suggests that isn't the case. 

"Apart from the ECB, there are currently no big wallets in the EU that are capable of supporting Spain and Italy," said Willem Buiter, Citigroup Inc.'s chief economist. 

One senior London banker said his bank is drawing in untapped credit lines to companies in Spain and Italy. An official with another major European bank said it is considering similar moves, although it is nervous that such actions could send a destabilizing signal that the bank is in trouble. 

The departure of a country from the euro zone could expose banks with big operations in such countries to the risk of rapid currency devaluations and other turmoil. One banker said his bank was increasing its hedging to protect itself. An official at another bank said the situation in Italy is being monitored "moment by moment." 

The defensive moves have the potential to put further pressure on those economies by reducing the already limited supply of credit. This occurred at the outset of the U.S. financial crisis in 2008, deepening the recession. One official said the situation in Italy is being monitored "moment by moment." 

Officials at some banks said they sliced their exposures to at-risk countries more than a year ago and so new steps are unnecessary. Banks are also closely monitoring their funding positions, alert to the possibility that panicky depositors will start yanking funds from lenders connected to the euro-zone crisis, industry officials say. 

There are signs that some depositors, such as the U.S. money-market funds that represent a key source of funds for many European banks, are growing increasingly jittery. Officials with two relatively healthy European banks said they recently have been attracting more short-term deposits, despite the fact that they are offering ultra-low interest rates. The officials said the uptick in deposits is indicative of a flight to safety... 

In the U.S., a main gauge of stress in the credit market shows increasing worries about counterparty risk as the euro-zone debt troubles increasingly threaten to spill over into larger economies. The two-year U.S. swap spread, which measures the gap between swap rates and Treasury yields and is considered a prime indicator of risk aversion, widened to 0.30 percentage point, 0.015 percentage point wider from late Monday. 

Swap spreads often move in tandem with credit spreads and are a sign that traders think their partners in an interest-rate swap trade will fail to hold up their end of the trade. 

Part of the reason for the increased fears surrounding the continent's banks is that European regulators on Friday plan to announce results of their months-long "stress test" of 91 top lenders. Senior bank executives and regulators in several countries are worried the increased disclosures banks must make as part of the process could fuel market fears by casting their financial positions in a poor light, say people familiar with the matter. 

Disclosure does not cast a bank's financial position in a poor light.  Disclosure just shows what a bank's financial position actually is.  How the market interprets that position is what cast it in a good or bad light. 

Spain and Italy show that the key to solving the European sovereign debt crisis is current asset level disclosure

A Wall Street Journal article laid out how the European sovereign debt crisis is linked to the bank solvency crisis.  To solve either crisis requires solving both crises.

This blog recommends a solution based on the full implementation of the FDR Framework.

The first step to solving the banking crisis, is disclosure of each bank's current asset and liability-level data.  Without this disclosure, market participants do not know which banks are solvent and which are not.  Without this disclosure, governments do not know which banks are solvent and which are not.

With this disclosure, not only do market participants including governments know which banks are solvent and which are not, but everyone knows how much capital the insolvent banks need to restore their solvency.

Suddenly, solving the bank solvency crisis becomes an easier task because all the knowable information is known.  The total amount of capital needed is known.

Now the question becomes where does this capital come from.

This brings us to the second step which is to solve the sovereign debt crisis.  Again, the goal is to first figure out what is an appropriate debt level for each country based on its economic capacity to carry the debt and still provide its citizens with a level of services consistent with promoting economic growth.

Suddenly, solving the sovereign crisis becomes an easier task as the total amount of capital needed is known.

Now the question becomes where does this capital come from.

There are many choices like purchasing discounted debt or forcing write-downs or issuing equity for raising capital.  With disclosure, it is much easier to determine which choice makes the most sense for each situation.  More importantly, there is reason to believe that as the capital is raised, the crisis is ended.

If any doubt remained over how closely Europe's sovereign and banking crises are intertwined, the latest contagion has laid the linkages bare. 

Shares in Italian and Spanish banks have slumped as their governments' debt costs soar; many now trade below their post-Lehman lows. But while Italy's banks are a binary bet on a euro-zone solution to its debt crisis, Spain's banking woes are more fundamental. 

 Italy's bank woes are directly linked to the sovereign-debt crisis. Until Italy found itself at the center of the market storm last week, Italian banks looked relatively strong. Between them, they have raised more than €8 billion ($11.22 billion) of capital this year and most banks now have an average core Tier 1 ratio above 8%. Italian banks also have relatively low reliance on wholesale funding. Until recently, the market's biggest concern was the sector's low profitability, reflecting high costs, low credit growth and low interest rates.

But the loss of market confidence in the sovereign has raised fresh worries. Italian banks own government bonds equivalent to 13% of total bank assets—among the highest exposure of any major economy banking system, according to the International Monetary Fund. In contrast, Spanish banks' exposure to their own government is just 6.8% of bank assets; for U.S. banks, it is 5% and the U.K. just 1.5%. The only banking system more exposed to its own government is Japan's at 24% of bank assets. 

The good news for Italian banks is that if the euro zone does succeed in addressing its sovereign-debt crisis, share prices might quickly recover. Although the turmoil in Italy partly reflects fiscal and political concerns, the biggest problem has been Germany's insistence on private-sector involvement in any fresh Greek debt deal. This has spooked investors who fear they will be forced to take losses as a first rather than a last resort. A solution that avoided that would reassure bondholders. 

But Spain's banks won't escape the spotlight so easily. The market believes the banking sector is woefully undercapitalized and the latest volatility will further hamper the initial public offerings of savings banks Bankia and Banca Civica—crucial for restoring confidence. Bankia looks particularly vulnerable as its IPO is constrained by the need to raise €4 billion without diluting its parent below 50%. 

Worse, heavy issuance of covered bonds has left Spanish banks with a shortage of collateral for future funding, according to UBS. 

To ease the pressure on Spain, a far-reaching euro-zone bailout package is needed that will pave the way for greater recognition of losses and comprehensive bank recapitalization. That could take months to arrange. Until then, Spanish banks will continue to suffer.

European stress tests to release unprecedented amount of data, confirms FDR Framework is the solution

According to a Reuters' article, even Andrea Enria, Chairman of the European Banking Authority that is overseeing the stress tests, realizes the need for an unprecedented amount of data to be disclosed on each individual bank.

This is an explicit acknowledgement that implementing the FDR Framework is necessary to restore confidence in the financial markets.

As regular readers know, under this framework, governments are responsible for ensuring that market participants can access all the useful, relevant information.  For their part, market participants are responsible for all gains and losses on their exposures so they have an incentive to analyze this information and use the results of the analysis to set the price and amount of their exposure.

It is only when the data is available that market participants can analyze it.  It is only after the market participants have analyzed the data, regardless of the result of this analysis, that market participants can move forward with confidence to set the price and amount of their exposure.

Where Mr. Enria and your humble blogger differ is the amount of data to disclose.

Under the FDR Framework, the data that should be disclosed to market participants is all the useful, relevant information.  For banks, this is their current asset and liability-level data.

However, this is not what the regulators will release.  They are still searching for a half-way house that allows them to protect their information monopoly.

For example, they will release summary level reports showing each bank's exposure to Greece by amount and maturity.  The problem with summary level reports is that they hide the true data needed to evaluate the risk of the individual underlying positions.

It cannot be said frequently enough that regulators need to stop gambling with the stability of the financial system and give up their information monopoly on the individual underlying positions.  This is the data that market participants need if they are going to be able to accurately assess risk and subsequently adjust both the price and amount of their exposure.

This year's health check of Europe's banks will provide "unprecedented" new insight about the industry that will be useful in a time of market turmoil, the head of the regulator overseeing the test said on Monday, Jul 11 2011. 

"We are still in a very fragile area," Andrea Enria, chairman of the European Banking Authority (EBA), said in regard to current market conditions. 

He said the EBA will for the first time look at confidential data and challenge it, before releasing it for supervisors and investors to assess. 

"We will put an unprecedented amount of data out there," Enria said. 

There had been calls from some countries, including Germany, to limit the amount of data that is disclosed. 

In a letter to the EBA obtained by Reuters, German banking association ZKA (Zentraler Kreditausschuss), which represents the five associations of German banks, warned that "should publication take place in the envisaged form, we fear that it will not help in any way to build confidence or calm the markets -- on the contrary, quite the opposite is likely to occur." 

"Given the tense situation which already exists in money and capital markets, we believe publishing the results with the present level of detail would exacerbate the sovereign debt crisis," it added. 

The warning however seemed to have fallen on deaf ears. 

The templates on how much data would be disclosed had not been changed and the EBA had not replied to the letter, according to sources close to the association. 

The ZKA complained that publication would reveal "deep insight into a bank's business strategy, market positioning and risk profile on a hitherto unprecedented scale." 

It raised concerns that "the possibility cannot be excluded that publication of the stress test results in their present form will spark not only market volatility, but also targeted speculation against individual banks." 

The European Union watchdog is stress testing 91 lenders to see whether they can still stand on their own feet in the face of scenarios such as the economy shrinking for two consecutive years or big falls in house prices. 

The aim is to restore investor confidence in a sector still being propped up by taxpayers in parts and under pressure to contribute to a Greek bailout. 

Ernst & Young warn that Europe's bank stress tests will not restore market confidence

Thanks to an article in the Telegraph, we know that Ernst & Young supports the arguments and conclusions put forth on this blog when it comes to Europe's stress tests.

Specifically, Ernst & Young supports the prediction under the FDR Framework that the only part of the stress tests that is likely to impact confidence is the disclosure of data and that this impact occurs because market participants can analyze this data and draw their own conclusions.

The European Banking Authority will publish the results to its second set of stress tests on Friday but the tests' credibility has already been called into doubt by the Ernst &Young Financial Services Eurozone Forecast. 

"Crucially, the adverse scenario still does not consider a European sovereign debt default. Moreover, the methodology overlooks the potential for damaging feedback loops to develop between banks and the broader economy at times of financial stress," the forecaster said. 

"We believe that the EU stress tests results will not significantly dampen risk aversion in wholesale funding markets." 

... The second round of stress tests, which are being conducted after the first set were completely discredited by the clean bill of health for Ireland's banks, were supposed to shore up confidence. However, the forecaster said: "It seems unlikely that the results will drive a wide-scale recapitalisation of southern banking systems that would help to assuage investors." 

One hope, however, is that the increased level of detail the lenders will publish will reduce uncertainty. "Banks will be required to disclose more details about the size of their exposures, which will help market participants to calculate the effect of larger stresses for themselves," the report said. 

"So while we believe the stress test results themselves are unlikely to dampen risk aversion significantly in the funding markets, enhanced clarity regarding the positions of banks should contribute toward reducing uncertainty." 

Ireland forcing banks to make loans even after bank rejects loan application

In an attempt to shorten that portion of the credit cycle where banks only fund very low risk loans, Ireland has introduced a program to over-ride the bankers and force them to make loans.  Regulators are now substituting their judgement of credit risk for the judgement of the banks' lending areas.

This is a development that has been under-reported by the mainstream media and opens up a whole series of issues like who is responsible for losses on these loans?  Granted, Ireland has effectively nationalized its banking system, but this puts even more of a sense of urgency under the need for implementing current asset and liability-level disclosure so that market participants can analyze both the banks and the Irish sovereign credit.

As reported in an article in the Irish Independent,

The Credit Review Office (CRO) will be able to challenge loan applications turned down by the banks of up to €500,000 from next week in a bid to free up more credit for Irish businesses. At the moment the office can review and dispute bank decisions on loans of up to €250,000. 

Finance Minister Michael Noonan sanctioned the higher limit yesterday to help small businesses, farmers and other borrowers to get more credit from AIB and Bank of Ireland. 

The CRO, headed by John Trethowan, looks at complaints from bank customers whose loan applications have been reviewed and has the power to dispute them. Mr Noonan said so far the office has challenged bank loan refusals amounting to over €1.75m and this has resulted in the granting of finance, which has protected 210 full-time and 13 part-time jobs. 

"This shows the effectiveness of the review process and the increase in the thresholds should protect even more jobs," he said yesterday. 

Mr Noonan hopes that by raising the limit to €500,000, more disappointed bank customers will challenge these decisions and have their loans granted. 

"Up to now the numbers of applications for review going to the Credit Review Office has been surprisingly low considering the volume of complaints about difficulties that SMEs are facing in accessing credit. 

"This increase will bring more refusals within the scope of the Credit Review Office," he said.

Ireland continues to confirm FDR Framework

As predicted under the FDR Framework, in the absence of current asset and liability-level disclosure, investors continue to doubt the solvency of the Irish banking system.  The Irish Times ran an article on the ongoing deposit drain occurring in the Irish banking system.

Ireland's borrowings from central banks rose in June as deposits continued to flow out of the country's financial system. 

Irish lenders borrowed €103 billion from the European Central Bank last month, compared with €102.3 billion in May. 

... "These numbers confirm that the pressures continue in terms of the Irish banking system even if the intensity of the problem has eased somewhat in recent months," said Austin Hughes, chief economist with KBC Bank. 

"The change in June is not marked because most of the footloose deposits have already left the system." 

... Ireland's banks are reliant on central bank loans to fund their day-to-day operations due to tens of billions of euro in deposit outflows and their exclusion from interbank lending markets.

Bailouts return to Europe [update]

[update]
As regular readers know, the stress tests run by the US did not restore confidence in investing in banks.  What restored confidence in investing in the 19 banks that were subject to the stress test was Treasury's pledging the full faith and credit of the US to ensure the solvency of these banks.  This only worked because investors perceived the US to have the ability to back up this pledge.

As regular readers know, Europe is still facing a solvency crisis.  So the regulators are trying to adopt the US solution:  stress tests and a government guarantee.

How did the financial regulators convince the governments to stand ready to bailout any bank that "fails" the stress test?  Whatever happened to the idea of shutting down these institutions?  If they are not able to "pass" a rigged test, isn't that a sign that they are insolvent?
__________________________________________

A Reuter's article reports on the return of bailouts in Europe.  Specifically, European countries are going to bailout their banks that fail the current round of stress tests in the event that the banks are unable to raise funds from the capital markets.

And why exactly would anyone want to invest in these banks in the absence of disclosure of their current assets and liability-level data?  How is an investor suppose to know if their investment is being made into a viable bank and not to support a bank dependent on extend and pretend that will ultimately collapse?

No matter how it is portrayed, the results of the stress test show these banks to essentially be insolvent.

Like the Spanish Cajas, these banks will be unable to access funds from private investors without disclosing their current assets and liability-level data.

European governments are ready to bail out those banks which cannot raise capital from investors after the EU details on July 15 which lenders have failed its latest, more vigorous stress test. 

The European Banking Authority (EBA) announced on Friday the publication date for the results of its check on 91 of the region's top lenders. These will be accompanied by measures to bolster capital for those that failed or nearly failed, in another attempt to reassure investors that European banks can withstand future shocks. 

According to a separate European Union draft document seen by Reuters, European countries will support banks that fail the stress tests if those lenders cannot raise capital from investors within six months. 

The paper, being prepared for EU finance ministers to approve on Tuesday, is an about-face from promises by G20 policymakers in the wake of the financial crisis that taxpayers would never have to bail out banks again. 

An official close to the EBA said all banks that fail must have a plan by September to plug the capital shortfall by the end of this year, as previously agreed by EU finance ministers. 

Those just above the pass mark will be more closely scrutinized and must also plan remedial actions but their implementation deadline remains unclear and could be clarified by finance ministers next Tuesday, the official said. 

Member states will be obliged to have backstops in place only for banks that actually fail the test, the official added. 

European Banking Federation Secretary General Guido Ravoet said some banks may struggle to find enough capital. 

"Is the European financial market deep enough to respond to the needs for capital? We are not the only sector looking for capital," Ravoet said.
This latest round of tests has been touted as being more rigorous than previous attempts, in which few banks failed, and finance ministers' officials are drawing up plans for how to deal with the fallout. 

The EU document also says lenders that nearly fail the tests will be put on a critical watch list in case they deteriorate. 

... According to the draft EU document, capital-raising plans should first be based on "private-sector measures, including ... retained earnings ... raising additional common equity or high-quality hybrid instruments from private investors, assets sales, mergers." 

But if the search for private capital leads nowhere, then governments should be ready to step in. 

Officials do, however, make provision for "the extreme case" if efforts to rehabilitate a bank fail and it threatens wider stability, recommending "a process of orderly restructuring and resolution." 

The number of banks declared by the EBA to have failed will either encourage investors that Europe is now coming clean with its banking problems, or if the tests are deemed too lax again, they will hurt the EU's already battered credibility. 

European Banking Authority turns to disclosure to save latest stress tests

The Wall Street Journal ran an article on the latest European bank stress tests.  In an attempt to make the results credible, data on banks' credit and sovereign exposures will be published.  The hope is that market participants will find this data sufficient to run their own analysis and confirm the findings of the stress test exercise.

As this blog has said repeatedly, what ultimately instills confidence in the financial markets is disclosure that allows market participants to run their own analysis.

The idea that the regulators should run stress tests as a means of instilling market confidence is fundamentally flawed.  Regulators should run them for their own internal purposes, but never for publication.

Why?  Because publishing the results of the stress tests has the potential to make it look like regulators do not know what they are doing.  Look what happened with the last round of European stress tests (shortly after completion, banks that passed the test in Ireland were nationalized).

The idea behind limited disclosure of banks' credit and sovereign exposure is also flawed.  Once the decision has been made to disclose these exposures, there is no logical stopping point before asset-level disclosure.  All market participants know that data summaries mask a multitude of sins.

It is far better for the regulators to give up their information monopoly and require the banks to disclose their current asset and liability-level data to all market participants (including competitors and credit and equity market analysts).  This way, market participants can run stress tests on the banks and the regulators can piggy-back off of their efforts.

The European Banking Authority said Friday that it will publish the results of this year's round of stress tests on European Union banks July 15. ... A full, bank-by-bank breakdown of the results, complete with data on banks' credit and sovereign exposures, will be published. 

... As reported, some 91 banks and banking groups have been subjected to the tests this year, and have to show that they can keep their level of core tier 1 capital above 5% of risk-weighted assets, even in the event of a severe economic slowdown and renewed market stress over the next two years. 

... Public attention to the stress test process this year has again concentrated on the simple "pass" or "fail" process. However, authorities have stressed that the greater importance of the exercise lies in providing transparency on the risks and potential weaknesses of the banks taking the test, allowing the market to draw its own conclusions as to their long-term stability.

The Financial Times carried an interesting article that provides far more color on the latest European bank stress tests.

As bridge designers have learnt, the best way to prevent disaster is to implement effective stress-testing that takes into account not just individual actions but also herd behaviour. That is just what the European Banking Authority, the European Union’s new regulator, aims to accomplish. 

Next week, it is set to publish the long-awaited results of an ambitious exercise to stretch the balance sheets of 91 banks in 23 countries almost to breaking point. 

The results are being closely watched – not only by banks themselves but also by investors and policymakers. How many institutions will fail? How many will just squeak by the pass mark that requires them to maintain top-quality “core tier one” capital equal to 5 per cent of their assets, even after a disaster scenario? How much capital will those banks be forced to raise? 

The answers, and the capital and risk analysis that comes with them, could have a profound effect both on share prices and governments’ attitudes to their banks. 

Among the most scrutinised information will be unprecedented disclosure of loan portfolios and holdings of sovereign debt, including maturity profiles – particularly timely given that Greece is teetering on the brink of default and that any sovereign debt restructuring could have big ramifications for the French and German banks that are the leading holders of Greek government bonds. 

Regulators say the exercise is vital to force banks to be honest about potential risks. “It’s about overcoming disaster myopia in some firms,” says one. 

For years, banks have run their own internal tests that model for isolated stresses: how the investment portfolio would withstand a 40 per cent slump in share prices, say; or what a 2 per cent rise in unemployment would do to the likelihood of homebuyers defaulting on their mortgage repayments. 

As computer modelling improved, regulators began to use their own scenarios to evaluate soundness. But only since the financial crisis has stress-testing become a vital part of the regulatory arsenal. 

Attempts by increasingly sophisticated tests to model the effects of simultaneous, interdependent changes reflect the big lesson of the financial crisis – that systemic risk resulting from the interconnectedness of an increasingly complex financial sector can be economically disastrous. 

21st century information technology is not limited to the regulators, but exists in abundance with market participants.  If there were current asset and liability-level disclosure, market participants would regularly stress test counter-parties and adjust the pricing and amount of their exposure to the counter-parties based on the results.

As the US showed two years ago, tough transparent testing can also reassure jittery investors, particularly important with the troubles of the eurozone’s peripheral nations continuing to dominate the news.

As previously discussed, the "success" of the US stress tests was a function of Treasury pledging the full faith and credit of the US to support the banks, not anything reported as a result of the stress test.

This pledge is not an option for Europe as the size of the national banking sectors exceeds the capacity of each country to borrow enough money to bailout the banks headquartered in that country.

The EBA’s aims are twofold: first, to strengthen the system by pushing banks that are thinly capitalised relative to their underlying risks into raising fresh equity: and second, to convince the world about that strength – helping investors, particularly from outside Europe, to differentiate among eurozone banks and stop shunning them en masse.

Said another way, to answer the question of who is solvent and who is not.

... Few are convinced that the EBA can dispel such fears. Last year’s debut test in Europe, administered by the Committee of European Banking Supervisors, the EBA’s more flimsy predecessor, was discredited within months of completion. It gave a clean bill of health to all but seven of the 91 banks tested, identifying an aggregate capital shortfall of only €3.5bn ($4.7bn), way below the €30bn-€40bn estimates touted by bank analysts. 

The results buoyed market sentiment initially. But by year-end Irish banks that passed had to be rescued as part of a massive EU and International Monetary Fund bail-out. As the bridge engineers might say, it was the “wrong sort of testing”. 

This year’s test has also raised concern. At first, it seemed it would make similar mistakes to its predecessor. When the scenarios emerged in March, several were actually more benign than a year ago – including a 15 per cent equity markets fall, rather than the 20 per cent used in 2010, and a more benign economic environment. 

The timing is ominous, too. With Greece at risk of sovereign default, any test result that underplays that likelihood will be dismissed by the markets as puff. “If there is even a selective default [of certain Greek bonds], the test result could end up looking horribly like the Irish scenario last year,” admits one European government adviser.

As discussed above, this is why the regulators should make sure current asset and liability-level data is disclosed to all market participants and not be putting their credibility at risk by disclosing the results of stress tests they run.

... A few months ago, however, hopes of a credible outcome looked slim. In April, when the first round of results began trickling in to the EBA’s modest headquarters in a London skyscraper, Mr Enria’s heart sank. With the process of testing delegated to national regulators and then in turn to the banks themselves, he had clearly left them too much scope to make optimistic assumptions and exploit loopholes. Crucially, most had assumed there was no possibility that Greece would default. 

The EBA decided it had to come down hard to retain credibility. It sent out new guidance in June requiring all the banks to run their data again to address what Mr Enria has tactfully referred to in public as “inconsistencies and excessive optimism”. 

The letter made clear that strategic changes other than capital raising made after December 31 2010 could not be used to sweeten the results. The EBA also warned banks to rethink the impact of a sudden rise in interest rates – many had assumed they would benefit from bigger lending margins, rather than suffer as a result of market turmoil.

It was on sovereign debt, however, that the EBA’s letter announced its most significant change. Banks were told to assume specified potential downgrades in sovereign credit ratings, spelling out, for example, that debt rated triple C – the lowest possible before default, and the rating now applied to Greece – had a 36 per cent chance of defaulting and that they should model for losses of 40 per cent if that happened. 

The clampdown was Mr Enria’s way of addressing the biggest criticism of the tests – that political concerns in EU institutions meant the EBA could not be seen to countenance a default of a eurozone sovereign borrower such as Greece, despite the growing possibility of just such an event. 

By insisting on the rating agency methodology, the EBA was able to maintain that it was not breaching the taboo against imposing a formal “haircut” – or enforced loss – on the value of Greek sovereign bonds. But the tactic essentially had the same effect – to the dismay of Greek banks, several of which now look more likely to fail. Markets, on the contrary, are heartened by this more stringent approach. 

The challenge now is to force capital raisings on banks that fail or come close to doing so. European governments have already pledged that by the time of publication next week they will have concrete state-backed mechanisms in place to forcibly recapitalise banks within six months. That is another vast improvement on 2010, when the test’s limited bark came with no bite at all. 

Exactly how credible will a state-backed mechanism for Greek banks be?  Yet another reason to opt for disclosure and keeping the results of regulator performed stress tests to the regulators.