The stress test focuses mainly on credit and market risks, including the exposures to European sovereign debt. The focus of the stress test is on capital adequacy; liquidity risks were not directly stress tested.
This is just one of the major limitations of the stress test results as they do not assume a real world scenario. During times of economic dislocations and fears, the market becomes increasingly concerned about bank liquidity considering they are all leveraged 20 or more to 1 and face significant rollover risk of short term debt instruments (e.g. Bear Stearns). I guess the EU test assumes the central bank will always be there to provide liquidity to all major banks regardless of their collateral quality. The report goes on to say:
This results in a set of haircuts to be applied to all EU sovereign bond holdings in the trading books of the banks in the sample.In my opinion, this is the most significant deficiency regarding the stress test. Under the scenario, banks only have to take a haircut on their holdings if they are in their trading book as compared to their banking book (held to maturity). Morgan Stanley did a recent survey and found that 90% of sovereign debt held by banks is in their banking book, and only 10% is in their trading book. All debt classified as a held to maturity does not face mark to market accounting. I wonder how banks are accounting for Greek 10-year debt which they bought under 5% since it is now trading at 10%? I guess they can assume that since the EU decreed that no country will ever default, then they never have to adjust the value of their Greek holdings. In reality, the debt should be written down by about 30-40% because it is, as we say, "significantly impaired." Another interesting fact in the stress tests is the amount of government support to the European banking system:
It should be noted that the aggregate Tier 1 capital ratio incorporates approximately 169.6 bn € of government capital support provided until 1 July 2010, which represents approximately 1.2 percentage point of the aggregate Tier 1 capital ratio. As such, government support form an integral and stable part of the Tier 1 capital ratios of the banks in question. It is not expected that any withdrawal of government support measures could take place without appropriate substitution by private funding sources, where relevant.You can see what a real sham this test was since the conclusion was that the majority of European banks need no new capital. European banks have currently received 170 billion in capital from various governments, which represents 1.2% of their mandatory 6% tier 1 capital or 20% of their capital. It seems that this financial support is likely permanent unless the banks can con a few sovereign wealth funds to invest in them. In conclusion, the EU report states:
The aggregate results suggest a rather strong resilience for the EU banking system as a whole and may appear reassuring for the banks in the exercise, although it should be emphasized that this outcome is partly due to the continued reliance on government support for a number of institutions.So let me get this straight--the entire European banking system is strong, healthy, etc., as long as it is completely back-stopped against losses by national governments (taxpayers). Under this specious reasoning, why even have a stress test since banks no longer have to suffer losses and can rely on unlimited financial support from governments in perpetuity?
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