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How Effective Is The Eurozone Stress Test On European Confidence?
Malaysia Perspective | 24 August 2010

Written By Mason Lim

The global financial crisis and the effects on the economies of Europe are so large a concern among regulators in the continent, that they conducted tests on 91 European Union banks recently. The underlying worry is that if banks have confidence issues, it would lead to the reluctance of the system in general to trade with one another. This lack of confidence became acute three months ago when the Greek debt crisis showed signs of tormenting Spain, Portugal and Ireland as well as exposing deep weaknesses and disagreements in the Eurozone. The concern was that governments in weaker economies having exacerbated their deficits and debt by rescuing some banks, were finding that the debt bonds they issued might become unattractive to banks. In normal times, banks hold and buy large quantities of sovereign bonds, considered low risk, easily convertible into cash and therefore representing a matching factor of top quality so-called Tier One capital.

The stress-test results found that only seven banks, five in Spain and one each in Germany and Greece, were under-capitalised and deemed a financial risk. The findings of the seven banks however did not surprise investors as the five Spanish banks were largely small entities catering to regional needs while the German bank has already been taken over by the government as a result of its earlier failings. The same applies to the Greek bank in question.

Not Everyone Is Convinced
However analysts were instantly dismissive of the tests, saying examiners had set the bar too low to assess the capacity of European banks, many of which hold bonds issued by debt-riddled governments, to overcome fresh financial pressures. Swiss Invest strategist Anthony Peter was cynical of the tests in the first place. His concern is based on the methodology for the stress test. Banks’ performance was modelled against three theoretical scenarios.

Firstly the benchmark case, which looked at a bank’s financial strength over the next two years assuming current growth trends were maintained. This was followed by two adverse scenarios, the first involving two years of worsening economic conditions, and the second based on a sovereign shock whereby European government bond values would fall to rock bottom levels. What this meant in effect was that a varying discount was applied to the value of European government debt, with the UK bond market down just over 10% in the most stressed conditions, while Greek paper was given a 23% haircut.

The tests were conducted under the guidance of the Committee of European Banking Supervisors (CEBS) by domestic regulators, with the Financial Services Authority overseeing the process in the UK. All the tests relied on data supplied by the banks and verified by their local regulator, leading to suggestions that the implementation of the scenarios depended to some degree on the local authorities.

The concern is that many European nations don’t have the funds available to bail out their lenders. Spain earlier this year drew up plans for a 100billion Euro bank rescue fund, but said it would raise the money in the markets as and when it needed it. Only 2billion Euro has been raised so far. To bail out the banks, the Spanish government would have to raise sovereign debt – putting it at the mercy of the markets.

But this is not just a Spanish problem. It is expected that if other smaller nations were to face a similar scenario, they may not be treated so kindly. That’s where the European Financial Stability Facility (EFSF) comes in. The EFSF, formed under the 750billion Euro European and International Monetary Fund bail-out plan struck in May, can issue up to 440billion Euros’ to stricken Eurozone countries. If governments are rejected by the markets, the EFSF is their last port of call.

The funds however, come with a condition attached to it. Applications for the money will only be approved if the governments can persuade the IMF and Brussels that they will be able to repay the loan, which is likely to mean further austerity. On top of which, the borrowing country will have to pay a punitive rate. Once Brussels and the IMF are satisfied, the EFSF will issue bonds backed by all European nations to raise the sum required. However, a measure of the success of the stress test exercise should become apparent in the movement of two key inter-bank interest rates, the Libor rate for dollars and the Euro-based Euribor rate, in the days to come.

US & Asian Markets React And The Euro Rises
In the US market however, investors bought stocks based on their assumption of reassuring news in Europe. The announcement by European regulators, that only a handful of banks would struggle if Europe’s economy weakens, helped send the Dow Jones industrial average up more than 100 points. Analysts were also convinced that the economic recovery is based on the positive news from Europe. Most financial stocks climbed in New York on confidence in the European banks ability to hold steady in the midst of disappointing news from Greece, Spain, Portugal and Ireland.

The same positives were evident in Asia as shares rose after Europe showed signs of growth. While nearly all stock markets in the region advanced — Japan’s Nikkei 225 stock average jumped 2.3 percent to 9,433.08 in broad-based gains. However, some analysts cautioned that the climb could be temporary.

The Euro reacted well to the news. The single currency went through a roller-coaster session on the day of the news, price initially traded calmly in Asia ahead of the much-awaited European stress-test results. The Euro remained under pressure in Europe on news report that Moody’s had placed Hungary’s sovereign rating under review for downgrade. Hungary’s PM Viktor Orban said he would not renew a deal on an IMF safety net and would row back on a commitment to cut the budget deficit to EU-prescribed levels next year. This led to the Euro falling to 1.2860. However, it then rallied briefly to 1.2966 after the release of much stronger-than-expected German IFO index. The index of German business confidence in July had risen to 106.2 from 101.8 – the largest increment since German reunification.

It continued rising later after the release of stress-test results which showed only 7 of the total 91 banks had failed the tests under the most adverse condition. Buying interest lifted the Euro up in late NY session as investors digested European bank stress-test results and the firmness in U.S. major stock markets boosted risk appetite.

If anything, the European banks stress test indicates that the European banking industry is on a path to recovery. Although the real effects can only be seen n inter-bank lending and the capital markets, analysts in general are confident positive news such as the one announced by the German IFO could help boost the Euro zone, at least in the near-term.

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