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Europe's banking check-up
Samah El-Shahat explains why the long-term prognosis is poor for Europe's sick banks.
Last Modified: 26 Jul 2010 10:11 GMT
Five Spanish banks, one German bank and one Greek bank failed the European stress tests [EPA]

The pan-European stress tests were published on Friday and we now know that seven - five Spanish, one German and one Greek - of the 91 banks failed.

However, these banks only need to raise the equivalent of $4.5bn - much less than the amount predicted by the markets, which was around the $70bn mark, and definitely much less than the amount American banks had to raise in April 2009 when their stress test results were published. In the US, 10 out of the 19 banks failed and needed extra money to the tune of $75bn.

So does this mean that Europe's banks are in fine health and were the tests a success?

Well that depends on why the stress tests were carried out. There are two chief reasons as to why one might want to conduct, and publish, stress tests. The first is to reduce investor uncertainty about Europe's banking system and the second is to recapitalise the most vulnerable banks. 

In my opinion, the tests were designed in such a way that it would have been very difficult to fail them. There were no surprises in the results.

Spain and Germany

Spain's five saving banks - or Cajas as they are called - have been in serious trouble since 2008 due to the exposure of the country's banking sector to the property market. Spain had a property market bubble that burst, leaving banks holding the equivalent of $574bn of worthless mortgages.

The markets will not be shocked by this news as Spain already has a contingency plan in place to deal with its ailing banks. It has been restructuring and merging its troubled saving banking sector. There used to be 40 saving banks, but the government's bailout and restructuring programme has reduced that number to 18. The Spanish government may react to the stress test results by merging the five identified as failing. Alternatively, there is a bailout fund it could resort to.

I am surprised that only one German bank - Hype real estate - failed the tests. I was expecting three or four of Germany's regional savings banks to fail due to their high debt exposure - nasty things are lurking on their balance sheets. Germany's regional banks were already exposed to a trillion dollars worth of sub-prime US debt, in addition to their high exposure to Spanish real estate debt, as well as Portuguese and Greek sovereign debt.

Note in how many varieties we now get debt. There is the already toxic subprime debt (worthless), the non-performing (i.e. already toxic) Spanish real estate debt (worthless again) and the potentially (i.e. most likely toxic) Greek sovereign debt (on the way to becoming worthless or at least having less worth). Imagine that on a banking menu or worse still on a bank's balance sheet.

Germany already has capital from its bank rescue fund, known as Soffin, which still has $323bn in credit guarantees and $67bn in capital to disburse - although the regional banks may look to state government for help. The relationship between these regional banks and the government has been their Achilles' heel. The incestuous relationship between politicians, self interest and the banks in Germany is quite extraordinary and is why the banks are in the serious mess they are. Just as in Spain, because these were non-listed banks they have had much less public scrutiny over the years.

Public relations exercise

IN DEPTH

  Counting the Cost: Testing the banks
  Money Talks: Do you trust your bank?
  Most European banks pass stress test

So what did I make of the tests, and returning to my original question, were they a success?

I think the tests were a public relations exercise to restore confidence in Europe's ailing and battered financial institutions. The good news is that they have provided a certain element of transparency which will, in turn, calm the markets. Investors will now finally know who holds the $2.6tn of sovereign debt and real estate debt exposure to Greece, Spain and Portugal. $2.6tn is close to a quarter of the EU's GDP, so this is no small sum. That is a good thing. The markets will react with confidence in the short term to the tests sensing that any information is better than no information on the status of the banks.

But the problem with the test is that while it is meant to gauge what would happen to the banks if financial Armageddon took place, the level of testing more closely resembled the banks being tickled by a feather (apologies to those for whom being tickled by a feather is indeed a very stressful experience). The tests did not include a sovereign debt default scenario - i.e. it did not examine what would happen to them if Greece were to default on its payments.

In the long term, investors will wake up to the fact that Greece defaulting on its sovereign debt is very likely, and that a good number of Europe's banks would still be undercapitalised to deal with such a shock.

The financial sector appears to be anticipating such a default, which is why, despite the IMF programme Greece has been following, the country's credit rating remains very poor.

As the tests did not deal with this probable scenario, the seven banks identified as needing more money to weather a worsening economic situation may not be the only ones in need of cash if Greece were to default.

I think that a number of other banks are far too exposed to Greek and other sovereign debt and, should Greece default, this will mean that they will be holding on to liabilities in their 'banking' book. The 'banking' book shows the bonds that you are holding until maturity - i.e. until pay day. But if Greece defaults these bonds would become worthless. But craftily the tests looked at the 'trading' rather than the 'banking' books of the banks. The 'trading' book is the bonds you are currently trading and at this time Greece's bonds still have value.

So in the short term European policymakers can enjoy their summer holidays feeling that they have restored some relative confidence in Europe's financial markets. But come Christmas, I fear they will be chocking on their Turkeys unless they take action to restructure their banks. All that toxic debt is on the banks' balance sheets and it is not going anywhere.

The stress tests provided us with the temperature of Europe's sick banks, but the disease is still on their balance sheets eating away at them like a cancer. Unless this is sorted, Europe will never achieve a long-lasting and sustainable economic recovery.

Source:
Al Jazeera
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