A glimpse into Europe's Bank Stress Test Scenarios

   Bloomberg has an article which outlines the the 3 scenarios involved in the European bank stress tests, which are looking more and more like a complete sham. The scenarios will simulate banks 2011 tier 1 capital assuming a yet undisclosed benchmark scenario, an adverse(recession), and a "sovereign shock," but not a sovereign default which kind of defeats the purpose. After all the threat to the European banks is not losses on corporate and real estate debt (just lie about that), but a default by Greece, Ireland, Spain, Portugal, and most of eastern Europe. But of course these stress tests are meant to be easy as possible for the banks to pass so that Europe can claim they have a "strong and healthy" banking system. The article goes on to state how the banks will have to account for sovereign debt losses:

Under accounting rules, banks have to adjust the value of sovereign bonds held in the trading book according to changes in market prices, said Konrad Becker, a financial analyst at Merck Finck & Co. in Munich. For government debt held in the banking book, lenders must write down their value only if there is serious doubt about a state’s ability to repay its debt in full or make interest payments, he said.

   No problem here for the major European banks--just transfer all of your sovereign debt into your banking book and repeat the EU's proclamation that no European country will ever default. So in the case of Greece you simply take a 1-2% haircut even though those 4% 10 year bonds you bought in 2008 are now yielding 10%. Under the EU's worst case sovereign shock scenario banks would have to:

assume that rising government-bond yields will push up borrowing costs, spurring defaults in the private sector that would lead to losses in lenders’ banking books, said the person.

   The real question is whether this charade will be enough to fool the market as it did in the US. Remember how American banks magically went from bankrupt institutions (in Fed-March 2009) to superior companies which were able to raise 100's of billions in new capital (by June-July 2009). We shall see.

Black Swan Insights

A glimpse into Europe's Bank Stress Test Scenarios