Forget stress tests – ring fencing banks from sovereigns is the real issue

So the results of the bank stress tests are out. Do they add anything from an investor viewpoint?

Well, despite the best efforts of the European banking Authority, we didn’t get the harmonised EU data we were hoping for. To say that there are inconsistencies in the data would be an understatement.

Disclosure varies hugely bank by bank, especially in areas such as their Loan to Value ratios for real estate lending, and that’s before you start trying to factor in the differences in the way property valuations are performed or indexed in each country. Banks, and in particular the tax systems and legal systems in which they operate, are still national. We’re a long way from a harmonised, EU wide banking sector.

There’s also no real information on banks’ liquidity positions. Assumed funding cost increases over the next two years are simply driven by the interest rate assumptions used, with little or no linkage to the banks’ actual and increasing costs of funding. It’s impossible to analyse what is happening to individual banks’ funding sources and costs. The EBA admits liquidity and funding is a critical issue but has backed away from making public its liquidity stress testing, presumably because they are concerned this might provoke further concerns.

One of the most frustrating issues for investors is that the EBA doesn’t stress test the legal entities to which investors and market counterparties are exposed or potentially exposed. So the French mutual groups are tested on a consolidated basis, when in fact debt and equity investors are taking exposure to very specific legal entities within the group, such as CASA within the Credit Agricole group, whose risk profile will be very different to that of the consolidated group.

However, the most important statement from the EBA in our view was the instruction to national regulators to require banks to raise core capital by any means possible, “including where necessary restrictions on dividends, deleveraging, issuance of fresh capital or conversion of lower quality instruments into Core Tier 1 capital.”

This means conversion of debt into equity where other sources of equity are unavailable. In Ireland this has already been accepted as necessary but in most EU countries regulators still do not have the legal powers to push through a forcible debt for equity conversion. Banks could of course try to achieve this via voluntary conversions, but ultimately the incentive for bondholders to agree to a conversion is limited unless there is the very real threat of a more draconian resolution regime to act as a “stick”.

Regulators and governments alike are well aware of this issue. The Financial Stability Board will this week put forward a consultation paper on the subject of international resolution regimes, along similar lines to the EU consultation published in January. These proposals aim to ensure governments can’t be forced to bail out the banking sector and thereby to ringfence the sovereign’s finances from those of its banks.

Equally, the critical issue of private sector burden sharing by the banks in any sovereign debt default also remains unsolved – until we get a clear framework for clarifying the role of banks in investing in sovereign debt, and find a mechanism for ensuring that all creditors, including banks, can and do take losses on investments in insolvent sovereigns, the umbilical cord between banks and sovereigns remains intact.

So rather than waste time sifting through stress test result spreadsheets, investors would be advised to analyse and understand the FSB resolution regime proposals for banks and the European Stability Mechanism framework for private sector burden sharing on sovereign debt. These are the critical issues facing investors right now, and all the stress tests do is highlight how important it is that a solution is found to enable banks and sovereigns to ringfence themselves from each other.

(For those interested in how the results might differ had sovereign debt haircuts been taken into consideration, see this calculator from Reuters Breakingviews)