ECB Stress Test Results Show Banks Struggling

Last Sunday, the European Central Bank announced its verdict on the stress tests it has been conducting for several months and, this time around, quite a few banks have failed them. The preceding stress tests in 2009 and 2011 had seriously diminished the ECB’s credibility by not detecting anything at all (even though Irish banks had passed the tests, they went bankrupt a few months later, and so did Dexia). This time, 25 banks failed, on a total of 130 being tested, and I would submit that this number is significant.

Should these tests be taken seriously, then, as the mainstream media is doing? Not really. First, this list only comprises second-rate banks such as Cyprus’s and Greece’s (for which no stress test is needed to realise they are broke) and Italian banks. The only important banks are Dexia and Monte dei Paschi, the difficulties of which have been well known for a long time. No large European systemic bank is part of the ones that failed the tests, and for good reason, because the failure of any one of them would provoke a destructive crisis (remember Lehman Brothers?)! The ECB only bothered to focus on a few lame ducks in order to reassure the markets.

There is also nothing to be reassured about when we take a look at the “black” scenarios invoked by the ECB for some European countries: A 20% price decline in real estate and on the stock markets (only!) – A slightly higher rate of unemployment than today’s (12.2% in France/today 10.9%, 27.1% in Spain/today 23.2%, 14.4% in Italy/today 12.2%) – Limited deflation (-0.3% in France, +0.6% in Italy) – A lower interest rate hike than what some countries have already experienced (5.8% for Italy while it had been at 7.4%, 5.6% for Spain while it had been at 7.6%) – And, finally, a very limited “recession” (-1.1% for France, -1.6% for Italy, -1.0% for Spain). This last number is more evocative of the ongoing slowdown than of a real crisis... those so-called “black” scenarios are lacking in stress!

Let’s also note that the main risk, i.e. sovereign debt, has been side-stepped. As everyone knows, a country cannot go bankrupt (unless its name is Greece or Cyprus... for now). The ECB is well behaved... it knows it is better to leave the States and the large banks alone.

And then, two days later, almost inadvertently, the ECB published a number that should have caused quite a commotion but that was not mentioned in the media: European banks hold 880 billion euros worth of bad or doubtful loans (e.g. at least 90 days late for payment), and this number represents 4% of their balance sheets. While 4% may not seem much, it does correspond to their mean leverage, or the ratio between their reserve funds and their liabilities, the “gross” leverage without any adjustment for risks (for example, for BNP Paribas: 1.8 trillion of assets for 72 billions of reserve funds – 72/1,800 = 0.04, or 4%); Deutsche Bank is at 3.1%, Société Générale is at 3.3%, ING Bank is at 4.6%).

4% represents the average leverage of European banks. So even if those loans are not totally lost (payments can start again, the bank may seize the debtor’s assets and sell them), we discover anyhow that European banks bad loans are about equal to their reserve funds... In other words, they are virtually bankrupt. Thank you, ECB, for this news!