Who says that Europeans don’t get Halloween? After more than a year in the making, the European Central Bank (“ECB”) just finished its most recent stress test and found that pretty much everything was kinda OK. Sure, a few banks here and there in the nether regions flunked, but perhaps with the exception of that most wonderful Banca Monte dei Paschi di Siena, no one flunked that badly.
Remember this is the second stress test. The last one was considered an embarrassing failure when several banks having passed the stress test, completely collapsed within months. Why do we think this one is better? This latest stress test feels to me like a dubious Halloween costume, except that whereas Halloween is an opportunity to make the benign nominally frightful; this is making the truly frightful nominally benign.
I read with interest Willem Buiter’s (the chief economist at Citigroup) insightful article in the Financial Times on Halloween making just this point and coining the absolutely delightful word of “Zombification” of the Eurozone banking system. He notes that an alternate stress test on a subset of the truly large European banks recently completed by a pair of well-respected academics, Viral Acharya (Director and C.V. Starr Professor of Economics, Department of Finance, New York University Stern School of Business,) and Sascha Steffen (Associate Professor of Finance and Karl-Heinz Kipp Chair in Research, ESMT European School of Management and Technology), calculated a capital shortfall of €450 billion! That’s about 20 times the ECB shortfall estimate. Guess which one is more right-ish?
From the transactional weeds, the on-the-ground experience suggests that these two professors are closer to the mark than is the ECB. The ECB’s estimate depended in large measure on cooperation and data from the national regulators–the same people who in large measure enabled the banking situation to get as bad as it is in the first place. The market now seems to be tumbling to the notion that the ECB stress test might not exactly be capturing the reality of the European banking market. Upon mature reflection, a number of thoughts appear to have occurred to the commentariat. First, as we pointed out in a commentary a few weeks ago, the European national regulators broadly permit the banks to include a large slug of tax-deferred assets in core capital. Strikingly, in order for these assets to be worth something, the banks must be profitable. Why in heaven would you test the ability of the banks to survive extraordinary difficult economic conditions yet at the same time validate such tax assets? And then, of course, these balance sheets are stuffed with almost 10% sovereign debt (based on the last estimate I saw). Those carry a zero risk weighting. How does that make sense? Capital really only matters in a stressed environment. Want to bet how liquid and stable the values of the dodgy sovereign debt on the periphery might be in a banking system meltdown? And on top of this, the ECB report card simply observes, in passing, that many of the major European banks did not appropriately risk rate many Level 3 assets and did not have systems in place that met ECB criteria. Feel better now?
Look, we already knew that Europe has been in economic straits and that there were problems lingering in the banking system. That’s new? Maybe not but it reminds us that there remains an absence of political will in Europe to address these demonstrably very serious problems. In the alternate universe of European policy elites, it seems that, if something is said often enough, and no one looks behind the curtain for long enough, and if we’re lucky enough and nothing really goes wrong, well then, perhaps someday it will all be ok. “Time heals all wounds?” Eventually, there is reversion to the mean? Maybe no matter how anemic our economies perform, they will ultimately get better…somehow, they always have, right? If everyone can agree to just believe hard enough (think Dorothy in the Wizard of Oz), then we won’t have to do anything dramatic, we won’t have to pull the candy bowl away and we won’t have to explain how we screwed up. That however seems like a startlingly frightening bet right now. Things do not always work out. Magical thinking can only take you so far.
But that’s not the only import of this tortured stress test. Actually, not even the most important. What really matters is that this latest stress test is more evidence, if truly more was needed, that we can’t really rely on government data nor government assurances about monetary and fiscal policy. We can no longer trust Western governments, to publish unspun, reliable data and champion policies that they, at least, think might work! I’m not arguing for Aristotelian perfection. My point here is not to display my naiveté, but, come on, at some point, systems become seriously dysfunctional when data is not honest and monetary and fiscal policies are knowingly disingenuous. This stress test is not, as advertised, confirmation that the banking system is in decent shape and Europe can begin to move forward with some confidence that the banking system will be there to support growth. What this stress test said to all the policy elites, is that we know the banking system is still a hash but we’re simply not going to do anything about it. We simply cannot face the consequences of acknowledging the system is seriously undercapitalized, so we’ll double down and trumpet that all is well, that the hard work of recapitalizing the European banking system has been done and we can move on to the broad sunlit uplands of positive GNP growth.
Okay, we get the joke, but this sort of thing has consequences. It makes private party decision making unsure, slow and timid. Before every commitment or action, one has to try to break the code and figure out, on their own, what data is good and what is verbal chaff ejected to confuse and distract the critics. To figure out what policies are actually designed to achieve an articulated policy goal and which amount to little more than misdirection and sleight of hand in pursuit of some other and often wholly political goal.
Back where I started, let me finish by wishing the European regulators luck, that the banking crisis will slowly abate, systems will heal and, as has always been the case, the financial condition of the European community will slowly get better. But let’s understand that this strategy of hope doesn’t often work. It’s a hell of a bet and the price of being wrong is quite large.