Sunday, 2 November 2014

The ECB stress test: same old, same old

The ECB performed another stress test on Europe's biggest banks. Here is the full report and here is the brief presentation. This stress test represents a yearlong audit of Europe's largest lenders to evaluate their hidden pressures and potential problems that could arise if another recession hits them. The conclusion was that 24 EU banks (out of the 130 tested) are about 25bn euros short of the money they would need to survive another potential financial crisis (this is what a stress test does - it assumes negative economic scenarios such as sharp declines in GDP and in equity markets, or spikes in interest rates, unemployment and oil prices, and then uses a series of simulations to calculate the losses of banks in the next several years to evaluate whether or not they have enough capital to 'weather the storm'). However the ECB has stated that half of these banks which failed the test (12) have already raised enough capital to make up for the shortfall.

What are the consequences on the real economy? If those 24 banks now need to raise additional capital (half of which have already done that), that only further constrains their lending, which is still the biggest cause of the sluggish recovery in the eurozone. Europe is literally between a rock and a hard place; on one hand you need to keep banks safe, but on the other you want them to lend more so as to start a robust recovery. The funny thing is, it has been like this for the past 3 years (recall my earlier blog posts on the subject: here, here and here). Currently the motivation to keep banks safe by making them comply with new regulatory standards and by forcing them to raise more safe capital (which was what partially caused the crisis in the first place) is dominating over the motivation to make them lend more money to the real economy. 

On the other hand the logic can also be reversed: the relative safety of the majority of the biggest banks that underwent the test can imply that they are now finally psychologically free to lend more. The banks have so far constrained themselves in taking new risks before it became clear that they are well capitalized and stable. After all this seems to have been the angle of the ECB: 
"The highly anticipated assessment of European banks was intended to remove a cloud of mistrust that has impeded lending in countries like Italy and Greece and left the entire eurozone struggling to avoid lapsing back into recession. By exposing the relatively small number of sick banks — of the 130 under review — the central bank aims to make it easier for the healthier ones to raise money that they can lend to customers." 
Source: Financial Times
But most importantly it seems that the stress test didn't cause any further market panic this time. Which is certainly good news. Despite catching headlines (Economist, Bloomberg, WSJ), the markets reacted quite well to the news (the euro went up against the dollar, and the EuroStoxx index rose). It also seems that this stress test was more credible than the earlier ones where some banks that were proclaimed to be healthy required bailouts later on (Belgium's Dexia is a notable example, after being declared completely safe and well-capitalized in July 2011, by the end of 2012 in received a 5.5bn euro bailout from France and Belgium). Finally even the analysis have immediately pointed out that they're moving on and that even though this constitutes as good news for bank stocks, from a macro point of view, it's a non-event.

So basically, back to the 'new normal' for Europe. The banks are safe, but at the same time unwilling to take any new risks. The US can serve as an example here, after its banks completed their bailouts, paid the money back, re-capitalized themselves, passed the stress tests, lending was still very low in the first few years. It grew at 1.9% annually. It has only recently picked up, in September this year, when total lending went up by 6.3%, while industrial and commercial loans went up by 12.3% (yearly change). Source: WSJ. If this is any indicator it should mean that Europe's recovery should also soon enough start following the US trajectory (a 2-3% annual GDP growth rate), however neither of the two recoveries were robust enough to close the gap left by the crisis. The labor market in the US is a clear indicator of this, despite the somewhat better US recovery. It points to a new, low-growth equilibrium, and it will stay this way as long as the many structural imbalances still remain unsolved. 

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