Gold surges as does the Swiss Franc whilst the Euro zone banking stress tests are completely flawed

15th July 2011 by Shaun Richards

After some delays leading to what has felt like an interminable wait the European Banking Authority will publish the results of its banking stress tests at 5 pm today. A total of 91 banks have been tested over the past three months with the highest component being the 21 Spanish banks and cajas being tested and there being a new entrant in that Norway has joined the procedure. Let us first examine the tests that will be applied.

The Stress Tests from the European Banking Authority

The adverse scenario, designed by the ECB, is more severe than the 2010 CEBS’ exercise in terms of deviation from the baseline forecast and probability that it materialises. It includes a marked deterioration in the main macro-economic variables, such as GDP (which falls four percentage points from the baseline compared to three in the 2010 exercise), unemployment, and house prices. The adverse scenario also includes a specific sovereign stress in the EU leading to further falls in the price of some EU bonds from the already stressed levels seen at end 2010. The sovereign haircuts will apply to positions in the trading book where losses would materialise and will be accompanied by full disclosure of all relevant sovereign holdings………….The methodologies and assumptions are designed to ensure the stress is applied consistently across all the banks in the exercise. In particular, the static balance sheet assumption freezes banks’ balance sheets of end 2010. This ensures consistency and prevents banks from claiming they would change their business model or sell off risky assets to mitigate the risk.

The capital threshold will be focused on a definition of core tier 1 capital which is more restrictive than the tier 1 threshold used last year.

For those who want the precise detail here is a link to it

What is the overall objective of these stress tests?

The Euro zone hopes that by showing that its banks can survive certain criteria that there will be a boost to to the European banking sector, which lets fact it could badly do with such a boost. By using words such as “adverse” for some of its tests it hopes that investors will believe that it demonstrates that Europe’s banks are in good shape.

Two flies in the ointment

In my opinion there are two fundamental flaws in the methodology applied here. If we examine the world environment we see fast moving dynamic developments some of which are predictable and some of which are not, the latter section I have labelled “expect the unexpected”. A steady-state stress test with x% for this and y% for that simply cannot cope as we do not know how x and y will vary. An example of this was the recent Irish banking stress test from March which assumed a 22% fall in commercial property prices under its adverse scenario which only 4 months later already looks like it will be exceeded!

If we return to the predictable section then the issue which will most concern investors today will be what will happen to Europe’s banks if a country defaults? We could add more than one country if we wished….Unfortunately EBA cannot under its mandate test for this as it is “unthinkable” according to one of the architects of this system the new head of the International Monetary Fund Christine Lagarde.

Last years test was a failure

Lest we forget last years version of these tests only failed some small banks and led to only 3.5 billion Euros of extra capital being required. This seemed laughable until only a few months later the Irish banking system collapsed! Suddenly a much more serious aspect was applied as Allied-Irish Bank and Bank of Ireland passed the tests then quickly collapsed. I think we can safely say that the 2010 version of these tests was an utter failure.

Problems with this years tests

I do not intend to go through the criteria one by one because as I explained earlier I believe that the methodology is flawed to start with. However in the week running up to the tests another flaw has emerged. Helaba which is one of the German landesbanken has refused the EBA permission to release its test results. Apart from the obvious inference that it failed we are left with the image of a spoilt child taking its football home with it and refusing to play anymore. Then we realise that the tests are not compulsory which is another flaw. In case you are wondering why Helaba pulled out it is over the definition of capital above which excludes the type of hybrid capital that the German landesbanken received as capital injections from the German government. So the German banks will be examined closely later to see if anyone else has been hit hard by this.


The system is horribly flawed but like may others I will be checking on it at 5pm today as sometimes some important information is released by mistake.


No I am not referring to the reforming of Spandau Ballet (for younger readers who missed the New Romantics era the song gold was their biggest hit) but to the recent surge in the price of gold. Yesterday it hit yet another new high reaching US $1594 per ounce. For UK readers we also saw a sterling high of £993 per ounce. As its main two uses in my opinion are as a safe haven and an inflation hedge I think that at this time we have seen both in play and this combination has driven it to new highs.

The safe haven play is driven by the problems with the Euro zone periphery which now includes Spain and Italy and fears over the United States and its debt ceiling charade which is currently playing out in Washington. Added to this was the hints of further monetary stimulus which the Chairman of the Federal Reserve Ben Bernanke provided this week in his testimony on Capitol Hill which led to a rise in inflation fears. A double whammy if you like.

On the subject of gold there was an interesting exchange between Senator Ron Paul and Ben Bernanke which went as follows.

Ron Paul: Is gold money?

Ben Bernanke: No. It’s a precious metal

I will be interested to hear readers thoughts on this subject as it was a fascinating exchange pushing the Fed’s chairman out of his comfort zone.

The consequences of the surge in the Swiss Franc

Here we have an example of exactly the reverse of what I often discuss as the Swiss Franc exchange rate has shown extraordinary strength since mid 2008. Just under 3 years ago the exchange rate with the Euro was 1.63 and this week it hit 1.15 (this is a slightly confusing situation where a lower number represents Swiss Franc strength). Now imagine that you are a Swiss exporter and the problems this must represent. This situation is not often discussed from the point of view of Switzerland but I remember a report from JP Morgan suggesting that an exchange rate of 1.29 versus the Euro could push her into recession. So there is quite a squeeze going on which proves that in these times even being a safe haven is not all its cracked up to be!

There have been suggestions as to what Switzerland could do about this but I am afraid my profession has not covered itself in glory with them. I read with incredulity earlier this year suggestions that Switzerland needed an increase in interest-rates which could only have been written by someone unaware of the monetary impact of a rising exchange-rate as it was plain that the exchange rate would do thr job and in fact probably more than what was required. Some are now suggesting that the Swiss National Bank should intervene in currency markets forgetting that it has tried and failed and at the last count was 26 billion Swiss Francs in debit because of it (as we stand the number has to be higher than that).

The past may offer a suggestion as back in the 1970s Switzeland taxed overseas holders of her currency which created the illusion/effect of her having negative interest-rates. Just to be clear this was only for overseas holders and she did not actually have negative interest-rates. Could it work? I am not sure but as she gets more desperate she might try again.

One interesting corollary of this is that trying to engineer the effect of negative interest-rates might help a surplus nation which is a safe haven. As many deficit nations have had it suggested as a prescription it begs the question are we in such a mess that everybody needs them? If so how do we ever get out of that? For now I have as the song put it “More questions than answers” for now but my initial thought is that one needs to be clear about real and nominal interest rates in this debate.

Anyway we have a link to gold here as of course the rise in the price of gold is contributing to the rise of the Swiss Franc. Whilst currency intervention put a hole in the Swiss National Banks annual accounts some ten billion Swiss Francs was put back in in by golds rise. Also with a much closer geographical link (Mayfair) some hedge funds left the UK to go to Switzerland to avoid taxes but hav ehtey lost more from a cost rises caused by a rising Swiss Franc.

More pain for Eastern European mortgage holders

I cannot move on from this subject without referring to this matter which I discussed in detail on the 24th of May. Since then if you held one of these mortgages the amount you owe has grown by just under 6% in Euro terms.

One of the countries affected has been Poland and courtesy of the Financial Times here is a chart for the Polish Zloty versus the Swiss Franc. From the point of view of a mortgagee it needs to be turned upside down.

Price and Value

On a hopefully lighter note I wish to discuss premiership values at one football club Aston Villa. Now prices on transfers are open to debate but they appear to have paid £24 million for Darren Bent sold Ashley Young for £17.5 million and Stewart Downing appears to be leaving for £20 million.

I invite comments as looking at it the best player (a subjective opinion) seems to have gone for the least money making me mull over the concept of price and value. I would welcome others thoughts.

6 thoughts on “Gold surges as does the Swiss Franc whilst the Euro zone banking stress tests are completely flawed”

  1. James says:

    Could I add another fly  to the ointment, as you so eloquently describe it above.
    Imagine that bank A is shown by these tests to have no exposure to sovereign debt, but a huge exposure to Bank B. Bank B has lent its entire balance sheet to Bank C, which in turn has lent its whole balance sheet to Greece and is bust.
    Unless you can trace this from reading the tests, you would conclude that Bank A is safe as a Swiss Franc, whereas in fact it is bust.
    In the real world, this of course will be hundreds of transactions and if you don’t know the counterparties right through to the end of the chain, how will you ever know what is safe?

    On another front, it’s also pretty comical that the tests, even if perfect, are 7 months out of date. Perhaps the Eurocrats think that a balance sheet stays the same in between stress tests?

    1. Anonymous says:

      Yes, this is indeed a very serious flaw in the rather pointless stress tests. My impression is that the tests have only PR value, like a lot that comes from the EBA and ECB. It’s all part of can-kicking. Substance is absent.

      Look forward to banks that pass the tests by a solid margin then fail when the real stress comes down the pike, a very probable event as things stand.

      What will happen to the European officials in that situation? History indicates that they will sail on in their jobs, oblivious to any inconvenience (or worse) beyond their doors. You have to sympathise, though, if they tell the truth the whole edifice will collapse, if they don’t it will just collapse a few weeks later.

  2. Alex Eames says:

    Ron Paul was awesome in that Q & A. Is gold money? Well it’s definitely a store of value, and it’s hard to ignore its trend over the last few years. I think his point though, was that according to the US constitution, a dollar is defined as a specific amount of gold. If that were still upheld and gold were legal tender, it would surely be money?

    What would you rather have? Gold stashed in a vault or paper (or electrons)? Which will be worth more in 10 years time? (Roll the dice and take a chance, do not pass Go, do not collect two hundred depreciating pounds).

  3. JW says:

    Re your last para, its analogous to Leasehold properties, say in Mayfair. Lower than expected prices because of very short Leases, ie Young only had 12 months to run on his contract so cost the least to buy, but is by far the most ‘valuable’ with an extended Lease.

  4. Anonymous says:

    Hi Shaun and fellow contributors. Is it not now obvious that we are entering a de facto gold standard because monetary conditions are grossly disfunctional. The deleveraging shock and bad debt ( whether recognised or kicked down the road) is distorting currency relationships  – it must be – fictionally creating more reserves is just adding to the disfunctioning – as Sir Mervyn said recently weird patterns of demand are developing.

    1. Anonymous says:

      Hi Shire

      The situation is continuously evolving I think. It would appear for example that overseas investors to some extent are setting a “Swiss Franc” standard and yet there is a limited supply at an ever higher price for them. There are a lot of consequences of this before we leave Switzerland’s borders let alone go outside them.

      We have travelled over time from mercantilism (gold and silver) to a gold standard to fiat money where will we go next? I am not sure but it is an irony that one of the reasons for scrapping the gold standard its fixed supply in an era of expansion of narrow money and QE now looks attractive to some again! We are in danger of coming full circle.

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