A stress-test too many?

While the publication of stress-tests of European banks’ performance could boost market confidence, the results could also tip banks over the edge.

The publication later this month of data on how European banks have performed in a stress-testing exercise will mark a watershed in the EU’s response to the financial crisis. If well executed, it could boost market confidence in Europe’s banking sector, and provide an opportunity to improve its long-term health. But with the deadline for publication looming, banks are concerned that governments have yet to prepare properly. There is also tension between Germany and other member states about how much information should be released, threatening markets’ faith in the exercise.

The stress-testing exercise is being carried out by the Committee of European Banking Supervisors (CEBS) in co-operation with national regulators. The exercise covers more than 100 financial institutions, including all those deemed to be of systemic importance to the EU’s economy. It will examine how banks would react to a sudden financial shock, including a member state defaulting on its debt. The results, including bank-by-bank data, are expected to be published on 23 July. Finance ministers will settle details of how and exactly how much data will be published at a meeting on 13 July. CEBS began the exercise in March.

Ending concerns

EU leaders decided in June to publish the data in the hope that it would end the markets’ concerns that banks have been hiding the true extent of their losses and their exposure to risk. These concerns have risen sharply in recent months, as markets have become less confident about the quality of the EU’s public debt, much of which is held by the banking sector. Investors’ anxieties have also been heightened by specific national circumstances, such as the collapse of Spain’s housing market, which caused the failure of CajaSur, a savings bank, in May.

Such concerns have made it more expensive for financial institutions to raise money on the interbank market, forcing the European Central Bank (ECB) to reintroduce emergency measures it first used after the collapse of Lehman Brothers, an investment bank, in September 2008.

Governments have said that publication of the results will show that, as Christine Lagarde (pictured), France’s finance minister, said on Sunday (4 July), “banks in Europe are solid and healthy”.

The decision to publish has also been strongly welcomed both by the ECB and by the G20 group of developed and emerging economies, which said on 27 June that the move would make a “substantial” contribution to global economic “well-being”. The US govern-ment has been pushing the EU to carry out a public stress-test for over a year.

But large parts of the EU’s banking sector are worried that markets may react negatively to the data. The British Bankers’ Association has warned that investors may misinterpret the results, or react irrationally to them, leading to a run on a “perfectly sound” bank.

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The Association of German Banks (BdB) is concerned that governments may not be ready to support financial institutions that are revealed to be undercapitalised, leaving them vulne-rable to a collapse in investor confidence. The BdB wants all member states to put in place a scheme equivalent to Germany’s bank rescue fund, Soffin, before the results are published.

Governments, however, are generally keen for banks to rely on private means, such as asset sales and stock issues, to raise any extra capital they may need. US banks largely relied on their own means to reinforce reserves after they were publicly stress-tested in May 2009.

The BdB is also concerned that testing standards may not be equal across the EU, placing some banks at a competitive disadvantage. It is seeking assurances on this point from CEBS.

Restructuring fears

Banks fear, in addition, that the European Commission or national governments may use the results as evidence of the need for further painful restructuring of the financial sector. The exercise will, for example, cover several of Germany’s regional banks, the Landesbanken, which market experts suspect are nursing major losses. The Commission has long pushed Germany to restructure these banks, which are heavily supported by the country’s regional governments. This, however, is a highly sensitive issue for Germany, which wants to preserve its regional banking model. Spain is expected to use the stress-test results to pressure its savings banks to merge into larger entities.

Investors remain concerned that member states, notably Germany, may find ways to undermine the transparency of the exercise, for fear of what it might expose. The German government has said that its national law on data privacy may prevent it from the releasing full details of the results, and Axel Weber, the president of Germany’s central bank, has said that he opposes full disclosure. Failure to publish data on all the banks tested would, however, place Germany firmly at odds with other member states, notably Spain, which is urging maximum transparency.

For governments, publication of the stress-test results is a risk and an opportunity. If the banking sector is essentially given a clean bill of health that convinces the markets, the move would be hailed as a triumph. But if member states are ill-prepared to respond to the markets’ response to the discovery of major problems, the stress-test could drive banks towards collapse.