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Monday, July 26, 2010

Analysis of the European Bank Stress Tests




Analysis:
Here are some headlines that I saw after the European bank stress tests were revealed:
“Euro Bears Vanish as Stress End Makes Goldman a Bull” (Bloomberg)
“Spanish, Other European Banks Rise After Stress Test Results‎” (WSJ)
“Vast majority of EU banks pass stress tests” (Yahoo)

Despite these positive-sounding headlines, the truth is that the stress tests were not tough enough. According to the results, seven banks lack adequate reserves to maintain a Tier 1 capital ratio of at least 6% in the event of a recession and sovereign-debt crisis. Among the banks, one is German, one is Greek, and five are Spanish. Furthermore, the tests concluded that the banks would only need to raise 3.5 billion euros ($4.5 billion) of capital. For many investors, these numbers sound too good to be true.

Bringing a bit of reality to the picture, Morgan Stanley’s head of European credit strategy claims that had the Tier 1 threshold been 7%, 24 of the banks would have failed. Another criticism coming from investors is that the tests ignore the majority of sovereign debt that banks hold. The bank exams only took a look at the trading books and ignored the banking books. In other words, the evaluations took into account potential losses only on government bonds that the banks trade, rather than those they are holding until maturity. This is a major problem because, according to a survey by Morgan Stanley, lenders hold about 90% of their Greek government bonds in their banking book and 10% in their trading book. Also, the tests assumed a loss of 23.1% on Greek debt, 14% on Portuguese debt, 12.3% on Spanish debt, 4.7% on German debt, 10% on UK debt, and 5.9% on French debt.

On the other hand, some argue that the very existence of the stress tests is a good sign. This is because it forces European national bank regulators to work with each other and keep a closer eye on troubled banks. Additionally, some say that the tests make it more likely that the government will bail out banks if needed. The argument is that government is more inclined to make good on its claim with a bailout if a so-called “safe” bank is about to fail.

Conclusion:

In my opinion, the stress tests do little to bring about certainty to the eurozone. In light of the tests, I am not convinced that the euro will break through 1.30 in the next few weeks. However, with that being said, the euro may continue to defy the odds and finish this month up strong.

Information obtained from Bloomberg and other news sources.

Daniel A.
Summer Analyst
Analyze Capital LLC
analyzecapital@gmail.com

3 comments:

  1. Very good post, i see you are EUR bear… currently still trading sideways… the technicals may for surely be in our favor

    ReplyDelete
  2. My 2 cents:
    http://forum.thelordoftrading.com/the-bull-the-bear-and-the-ugly-spreader-trading-forum-f1/roubini-and-jpmorgan-agree-euro-stress-tests-were-a-joke-t945.htm

    ReplyDelete
  3. Thanks for the input guys.

    ReplyDelete

 
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