**[investwise]** Fudging European Bank Tests Imply An Ultimate Destruction og The Euro

 

The European bank stress tests were a whitewash, of course. You'd have to have been particularly naïve to expect anything else. It's almost disappointing. I had a vague idea that the test results might be like one of Gordon Brown's budgets. You know the sort of thing - a glossy sheen of half-truths and not-quite-outright-lies disguising the true horror of the underlying economic situation. A roll-call of good news to distract the attention, while all the bad stuff and caveats are buried in the small print or left to the imagination. But to put it bluntly, Europe's regulators didn't even try to pretend that this was a serious exercise. Out of 91 banks, just seven failed. And those were the ones we knew were in a mess already. So what are we meant to make of all this? The stress tests failed Seven of the 91 banks stress-tested by the European Union failed, and need to raise €3.5bn in total between them. That's enough to tell you that the tests were too soft. That €3.5bn was "about a tenth of the lowest analyst estimate", reports Bloomberg - and analysts tend to be on the optimistic side. Barclays reckoned the banks might have needed to raise as much as €85bn. Five of the seven failures were Spanish cajas, which everyone knew were in trouble and Spain has already planned to recapitalise. Germany's Hypo Real Estate was another well-broadcast failure, which is already owned by the state. And there was one Greek bank, ATEbank, which is part-government-owned. In short, as Richard Cranfield of law firm Allen & Overy put it: "Arguably the failure here is not the banks concerned but the test itself." Where the tests went wrong So what was wrong with it? Well, as Wolfgang Munchau writes in the FT this morning, that there were three main problems. First, it left out some important institutions. That's perhaps excusable. Secondly, the stress test was looking for a tier one capital ratio of 6%. This is the amount of capital that a bank holds compared to its total assets. It's a core measure of how financially strong a bank is. The idea behind tier one capital is that it provides some protection against unexpected losses, before a bank has to raise any more money from taxpayers or the markets. But there's a problem here. As Robert Peston noted in a recent blog on the BBC, the calculation used by Europe's regulators includes "various forms of capital that the recent banking crisis showed were more-or-less-useless for absorbing losses." So on this basis, the tier one capital ratio is probably overly generous. But there's a third problem, much more important than either of these. Remember why we ended up getting the stress tests in the first place? Oh yeah - it's because Greece was on the verge of going bankrupt. And everyone was a bit worried as to what impact that might have on European banks' fragile balance sheets. So you might think that a credible stress test would have come up with some way of, well, testing for this scenario. No chance. As Munchau notes, "there was no provision for the possibility of sovereign default… this is like a car crash tester failing to consider the possibility of an oncoming vehicle." The stress tests only assumed a further (relatively small) fall in the value of government bonds that banks hold for short-term trading. The ones that they plan to hold to maturity were unaffected. That makes sense on the one hand. After all, day-to-day fluctuations in bond values are irrelevant if you plan to hang on to them until they are redeemed. But if a country defaults, then the problem is that they won't be redeemed. And this is what the stress tests completely failed to test for. The tests we really need won't happen As Chris Whalen of Risk Analytics told The Telegraph: "Everyone knows that is a sovereign story. These tests are a political exercise that tell us nothing useful. You have to test the states themselves for solvency." Unfortunately, that's not going to happen. Because the EU doesn't even want to admit to the possibility that a eurozone country might default on its debt. As for what this means right now - the euro is pretty flat against the dollar, while European stock markets are pretty flat too this morning after an earlier surge. I suspect it won't be long before the tests start being picked apart. I wouldn't be putting your euro shorts back on just yet, but you should probably start getting ready to do so. Safe Harbor Statement: Some forward looking statements on projections, estimates, expectations & outlook are included to enable a better comprehension of the Company prospects. Actual results may, however, differ materially from those stated on account of factors such as changes in government regulations, tax regimes, economic developments within India and the countries within which the Company conducts its business, exchange rate and interest rate movements, impact of competing products and their pricing, product demand and supply constraints.   Nothing in this article is, or should be construed as, investment advice.

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