ECB Stress Tests: The View of an Insider

Yves here. The ECB stress tests are starting to resemble the process that Japan’s Ministry of Finance used in dealing with zombie banks in its post-bubble years. The MOF would gradually acknowledge how bad the loan books were as the banks were able to make writeoffs (not that anyone was really fooled; foreign analysts were regularly making their own assessments). So the exercise is to pretend that the amount of disease revealed is credible, when those in the know recognize full well that is it much worse.

By Yanis Varoufakis. Originally published at his website

Klaus Kastner is a former banker from Austria who is also ‘afflicted’ with a deep concern for Greece; witness his excellent blog ObservingGreece. He has commented many times on this blog and, on the occasion of the ECB’s recent stress tests (and in response to this post) he sent me the following comment. His first hand experience of European banks renders is both useful and interesting. Read on…

Any stress test like the one which the ECB has performed is a good thing because, that is for sure, it got the bankers’ attention. I can say that from personal experience: the Austrian bank from which I retired a couple of years ago was one of the six Austrian banks subject to the stress test. Whenever I met former colleagues during the last months, I noticed that the stress test was on the top of their minds. In short: they were nervous. And it is always a good thing when bankers are nervous. Nervous about making bad loans; nervous about buying the wrong securities; nervous about getting caught at doing untoward things.

Having said that, it would be an illusion to think that all those banks which passed the test are ‘safe’. I looked up the figures of Deutsche Bank as of June 30, 2014. Their loans were only 23% of total assets. Financial assets of all kinds were almost 60% of their assets. Unlike loans where there are borrowers, behind financial assets there are counterparties and in the majority of cases they are not valued based on some notional amount or based on some tradeable value in a public market but, instead, based on complex formulae. If those formulae cease to be valid (like they did with LTCM back in 1998), the value of the assets is in the dark. More importantly, Deutsche’s consolidated equity was only 4% of total assets or a leverage of about 24:1. That’s a lot better than the 50:1 which it had a couple of years ago but it is still in the hedge fund category. Put differently, Deutsche is still a hedge fund with a small commercial bank attached to it. That’s a risk which cannot really be measured in terms of numbers.

As far as I know, the stress test did not at all take into account the interrelationship between banks (i. e. they examined banks on their own merits). Anyone who is interested in what those interrelationships can cause is well advised to read up on the history of LTCM back in 1998.

In summary, the stress test undoubtedly had a positive impact (at leat a short-term one) on the conduct of banks and bankers. However, anyone who concludes that the EZ financial system is on solid grounds is living in an illusion. The leverage of the large banks (mostly German and French) is far too high and they are far too reliant on ‘hot money’ for their refinancing. And structural issues have not been addressed at all. Many of the countries are totally overbanked leading to the situation where no bank on its own can make enough money without entering into undue risks. To me, the only answer is to increase the equity requirement based on notional balance sheet amounts (instead of only risk-weighted assets) which would lead to the necessary consolidations.