Stress test for major European Banks: what is it good for?

By: Jan Pieter Krahnen

This Friday, July 23^rd, the results of a Europe-wide stress test for 91 major European banks will be revealed. The test is intended to reduce the prevailing uncertainty about the stability of the national financial systems, and possibly to encourage confidence among banks. The institutions included in the test cover two thirds of Europe’s banking sector, reaching at least 50% of all domestic markets. Many people have doubted that such a stress test will be of great help in stabilizing the financial system. After all, the stress is only on paper, the stress scenarios underlying the results have been negotiated for some time between supervisors and central banks, and it is widely believed that all major banks will pass the test by a comfortable margin anyway. Considering these limitations,  is there any deeper value in the stress test?

I think the contribution of the stress test can nevertheless be significant, if its results are not discarded lightly.

First of all, the stress test measures the resilience of an individual bank’s capital to withstand a well-defined shock to its assets and liabilities. However, passing the test should not be mistaken for a signal of financial system stability as individual default risk is considered rather than systemic or collective risk. Furthermore, the test design does not allow for simultaneous variation of all relevant risk factors, but it assumes a particular set of risk factors realizations, including changes of macroeconomic factors like GDP or the consumer price index, an increase in credit spreads and a downward shift of sovereign bond prices. Therefore, failing the test is a sign of institutional weakness, while passing it is not automatically a sign of general financial health.

For this reason a stress test cannot substitute for a more systematic approach towards systemic risk, as it has been widely discussed in the context of the current G-20 agenda (see for example the recent report to the German government by the Issing Commission). However, the stress test can single out some weak institutions, measured by the standards defined by the stress test characteristics. Since revealing the information about the stress test failure will almost certainly increase the funding problems for these banks, a capital increase is the most likely consequence of poor stress test results. In the US in 2009, the results of the stress test were the basis for defining the level of required recapitalization of several banks, among them prominently Bank of America.

With respect to German banks, we have not heard much about contingency plans, but its overall strength and efficiency will probably also be judged by the resoluteness with which recaps and capital restructurings are addressed subsequent to July 23. In this sense, the stress test results are an excellent opportunity for the German regulator to demonstrate its willingness and its ability to strengthen capital standards on the bank level, as well as the financial architecture at a national level.

Is this view shared by the public, particularly by senior management in the financial industry? To find this out the Goethe University’s Center for Financial Studies (CFS) has conducted a representative survey among 500 top managers in the German financial industry, including among others banking, insurance asset management, consulting, auditing and supervision. The participants were asked to judge the likely effect of the current stress test on German banking. Interestingly, a clear majority of respondents state that this test will bolster the confidence of market participants in the safety and soundness of the financial system. Respondents who believe that the publication of stress test results will contribute to the stability of the financial system also predict banking supervision to increase its role subsequently. Furthermore, a strong majority of all participants believes that a predefined strategy how to deal with those institutions that fail the test is essential. Almost half of those requesting a strategy how to deal with ‘failing’ institutions believe that there is a need for restructuring the German banking sector. 

This view may prove particularly relevant in the case of the German State banks (Landesbanken), most of which are still looking for a viable business model.  Because of its fast implementation and its strong signalling character, a stress test may  become a catalyst for industrial change, overriding obstacles that otherwise would delay substantial changes in ownership and corporate control.

Taken together, we find two good reasons for cheering the ongoing stress test of banks in Europe. Provided that there is government backed support  in capital restructuring –either directly via capital injection or indirectly via insisting on additional equity issues-, the test is expected to raise the confidence of market participants, and to stabilize the interbank market. In addition, the test offers the opportunity for preventive capital restructuring, thereby strengthening the country’s financial architecture. Realizing these two good reasons for a financial stress test will impose some political stress on the government, on the state and on the national level. Let us hope that governments in Europe have prepared for this event.

 

The author is professor at the Goethe University Frankfurt and is director of the Center for Financial Studies at House of Finance

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