29th October 2014
The European Central Bank has missed the opportunity to rid Europe of the risk of systemic bank failures because its stress tests were simply not strict enough and did not require banks to raise enough capital.
Psigma chief investment officer Tom Becket says that with proper stress testing, the ECB could have allowed the market to “see the beginning of the end of the European crisis”.
Becket says the ECB should have forced banks to raise a large amount of fresh capital emulating the US which did so successfully in 2009. Europe’s banks should have been tested against a Japanese scenario of genuine prolonged deflation. Viewing the future in light of this risk would have meant the ECB would have required significantly more capital, he says.
In Psigma blog post published earlier this week, Becket accepts that elements of the stress tests were genuinely stressful. But he adds: “The underlying details of the tests show that the European Central Bank (ECB) has not been sufficiently strict with some of the pricing of assets in adverse scenarios. The ECB failed to decisively stake their claim for credibility”.
“We are comfortable that some parts of the macro scenarios they painted were sufficiently strict and would note that elements of the tests were in fact harsher than comparable tests carried out in the US earlier this year.
“Both the fact that the adverse scenario was not the potential “Japanese” episode that is entirely possible and the end result of claiming that European lenders need to only raise €9.5bn of further capital (when 2014’s raises are accounted for), despite the threat of a genuinely deflationary period, partially defeats the purpose of the whole practice. In simple terms; this wasn’t very stressful. Let’s put the amount to be raised in to context; the European banks surveyed have €22trn worth of assets.”
Becket says the other mistake involved some of the translational effects that the scenarios would have upon actual assets. “If the ECB had used a properly adverse scenario and implied a materially negative impact upon underlying assets, some of which had notably been held at make-believe prices, then the market could have started to see the beginning of the end of the “European crisis”.”
“We would have preferred that the ECB saw this as a “one-off” opportunity to finally rid the European financial markets of the potential systemic risk caused by major losses at European banks, much as the Americans did so successfully in 2009. We would have liked to have seen the ECB force European banks to raise a large amount of fresh capital, whether it was deemed necessary or not after the strengthening of their balance sheets already this year. Boringly, they have not done this and so the doubts will persist”.
He adds that there are certain reasons for hope. “Firstly, Mario Draghi has started to buy assets in the open market, starting with covered bonds and details of last week’s purchases brought some improvement in European equity markets on Monday afternoon, following AQR-inspired losses through the morning. Next up is the asset backed securities programme, which should hopefully be transformative to the prices of the assets that we own in our portfolios. Overall, we expect some limited success from the ECB’s own version of QE, although we would rather see a programme of efficient infrastructure spending with the money. Another reason not to be totally bearish is that there is evidence (finally) that money supply growth is starting to pick up, which hints at credit supply accelerating next year.”