European Banking | Trends

The degree to which the recent stress tests of big European banks by EU regulators lack credibility is becoming clear. Among a blizzard of analyses of the European Central Bank stress tests released on October 26, one by Viral Acharya of New York University and Sascha Steffen of Berlin’s European School of Management and Technology stands out. It shows that the 39 banks tested by the ECB need between €80 billion and €700 billion ($101 billion to $885 billion) to withstand a scenario that the researchers insist is “conceptually similar” to the ECB’s tests. That’s between 3.2 and 28 times as much as the €25 billion that the ECB estimated was required by all 130 banks it tested.

The main reason for the gap has to do with the difference in their definitions of capital. While the ECB, like the Federal Reserve in its own bank stress tests, includes such items as preferred stock, goodwill and other intangible assets along with equity and deferred tax assets when analyzing “core” bank capital, the two academics exclude everything but common equity because they deem everything else illiquid.

Steffen notes that goodwill and deferred tax assets, most of which reflect losses within the eurozone, were the “primary reason” Spanish banks passed the ECB stress tests.

And the ECB still allows individual country regulators considerable leeway in assessing banks’ capital and assets. German and French regulators assigned very little risk to holdings of sovereign debt, which helps explain why their banks were shown by the test to need no more than €200 million in capital under the so-called “adverse” scenario, which assumed a decline in eurozone baseline GDP of 1.9 % in 2014, 5.1% in 2015, and 6.6% in 2016. That scenario is similar to what the Fed used in its tests earlier this year.

But Steffen points out that Deutsche Bank, for example, holds more than €200 billion in sovereign debt but was judged by the ECB to have only €5 billion in risk-weighted assets. He and Acharya found that Deutsche Bank needed €77 billion in capital under their most severe scenario, compared with nothing under the ECB’s adverse scenario.

Moreover, the authorities ignored the fact that banks’ capital is correlated and therefore vulnerable to a downward price spiral. “Systemic risk and feedback effects … have been completely ignored in regulatory assessment,” Steffen and Acharya conclude. Meanwhile, a poll showed that 51% of 531 Bloomberg data service users don’t think the ECB tests were accurate.

The ECB has said it will follow up with a “business model review” of the region’s banks.