European bank stress tests, Road to Nowhere or Highway to Hell?

The European Banking Authority’s bank stress test results are due out on Friday evening.  Do the results mean anything or is it one for the talking heads? In our view it is a bit like taking a driving test – you can pass the test and yet still be a terrible driver.

The real test of whether anyone trusts you is whether people are prepared to get in the car with you. So whether or not banks pass the 5% Core Tier 1 stress test hurdle, the real test is whether investors and depositors trust them with their money over the long term, and there’s a long way to go before the European banks rebuild their reputation after a series of offences such as speeding, failing to indicate and poor steering.

Of course any raising of the bar in terms of testing could, in theory at least, reduce the number of accidents on the road going forward. The stress tests will give a degree of disclosure that we haven’t seen before, and it’s no surprise that German banks are reportedly squealing about giving so much information in a transparent standardised format. Even those banks not subject to the stress tests, such as Banca Popolare di Milano and Nationwide Building Society, will be expected by the market to provide the same disclosure, and a refusal will inevitably be seen as a sign of having something to hide, a bit like refusing to be breathalysed.

We also need to see how failures will be dealt with. There’s no point the traffic police simply letting offenders off with a caution and allowing them to stay on the road – they need to be locked up, rehabilitated and prevented from causing future accidents. Several European countries, including France and Italy, still do not have a credible resolution regime for dealing with failing banks, which could make driving in those countries potentially hazardous.

And it’s not just about the banks. There also needs to be major improvement in market infrastructure to make the roads safer for all drivers, such as improved repo and derivative market disclosure and practice, better payment and settlement system risk management and clearer international regulatory and accounting standards.

But ultimately what we need to test is the ability of sovereigns to separate themselves from their banks. Not only have the sovereigns guaranteed the banks, both explicitly and implicitly, but the banks are also funding the sovereigns, so there’s not much point stress testing the banks separately from their governments. After all, nobody has yet come up with a credible plan to recapitalise the Spanish banking sector, other than raising yet more quasi government debt via the FROB and injecting it as equity into the banks, perpetuating the excessive leverage of both banks and sovereign.

Regulators are hoping that proposals to ringfence the banks from the sovereign, such as senior bank debt bail-ins, higher capital requirements, and legal ringfencing of specific activities will break this link. These are all steps in the right direction, albeit slow ones. But until holders of sovereign debt, including the banks, can also be bailed-in and forced to take their share of losses in sovereign restructurings, the symbiotic link between the banks and their sovereigns remains. Until then, the roads remain dangerous, and the question is whether we’re on a Road to Nowhere or the Highway to Hell.