FinancialGuy Writes!

Newspaper headlines in the UK press over the past few days have lambasted the latest round of bank stress tests. Why?

The general sentiment seemed – at least to me – to be that the last tests were not suitably tough enough, and these won’t be either. Is that really the point of them?

I grant you that last time around, I thought that using a 6% minimum threshold seemed low. Very low. If you want banks to have stronger balance sheets and become less vulnerable, 6% seems like a piffling amount of capital to be holding.

But, you have to start somewhere.

When Lehman Brothers sank, it was believed to be leveraged 44 times! 6% is pretty strong in comparison to that!!

I have read a number of things about Basle III and must confess that even with my financial background, it is far too indepth for me to fathom. The general consensus seems to be that it won’t be strong enough (unless you run a bank of course!).

As long as the stress tests being run test for different scenarios each time AND gradually increase the amount of reserves that banks need to hold, isn’t that enough?

If we asked banks to increase their capital in time for a stress test in a few weeks time, and lets say that hypothetically it was set at 15% of reserves, there would be massive selling across Europe as banks liquidated anything and everything they could to get their balance sheets into shape.

I don’t think that is what we want either. Can you imagine the headlines then if markets dropped by 30% as ‘banks sell assets to fall in line with EU stress tests’? There would be much more EU bashing and negative press if a worldwide asset price crash were caused by these tests. Rightly so.

Therefore, it seems to me, that a gradual increase in capital reserves and a variety of scenarios being tested is actually a responsible way of improving the health of the banking sector. That appears to be what the new European Banking Authority is trying to do.

That said, it is important that these stress tests continue on a regular basis – perhaps two or three times per calendar year – long into the future. And that they are aiming for much higher capital reserves than they currently do.

Lets just hope that this is the plan. With a greater emphasis on openness and peer-review, we’ll find out in due course.

The main potential problem with this is if the banking sector fails to strengthen itself suitably in time and there is another crisis. Of course, it seems hard to declare this crisis ‘over’, but some worsening in the situation. If that happened, the European Banking Authority would not have acted quickly enough, and they would be held at fault to the world.

Needless to say, the actual banks have to keep doing things as well, which is not something that seems to be guaranteed.

In other words, the new EBA is caught between a rock and a hard place and many of the potential problems they face are out of their control. Welcome to Europe!

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