Stress-Test Magic Makes Greece’s Bust Disappear: Jonathan Weil

http://www.bloomberg.com/news/2011-07-14/stress-test-magic-makes-greece-s-bust-disappear-jonathan-weil.html?cmpid=

Better disclosure is no substitute for bad accounting. Europe’s lords of finance are going to give it a try anyway.

Tomorrow, the European Banking Authority plans to release its latest stress-test results for 91 banks in 21 countries. The good news for investors who believe in transparency is that thereports will disclose how much sovereign debt each lender held on its books at the end of last year, by country and maturity. The reports will also include detailed breakdowns of the banks’sovereign-related derivative positions.

It’s a different story when it comes to measuring thecapital cushion each bank has on hand to protect against future losses. The stress tests’ designers are letting the banks value the vast majority of their sovereign-debt holdings based on what they hope to be paid eventually, rather than those assets’market values. That’s just like last year’s widely ridiculed tests, regardless of the growing likelihood that Greece, Ireland or Portugal will default.

By coupling the presumably inflated stress-test scores with the data dump of new disclosures, Europe’s banking regulators in essence are telling the world’s investors: “Do it yourself.” A confidential document prepared by European Union officials offers a sneak preview of what the reaction might be.

“We expect the market will conduct its own calculations very soon after publication of the results,” said the draft EU report, obtained by Bloomberg News reporter Meera Louis. “There is a general expectation that the EBA stress test results will be challenged by market tests based on the additional disclosures and addressing the perceived weaknesses in the design of the test. The risks for financial stability,” it said, “should not be underestimated.”

Making Jokes

One reason for the new disclosures is that last year’s European stress tests were rightly perceived as a joke. Bank of Ireland Plc and Allied Irish Banks Plc passed them, shortly before they collapsed.
This time investors at least will have a chance to try to figure out which institutions don’t have as much capital in real life as Europe’s banking regulators are giving them credit for. No doubt, this weekend will be a busy one for many professional number crunchers.

The exam results will include a review of how well lenders’capital cushions would withstand a 0.5 percent economic contraction in the euro area this year, a 15 percent drop in European equity markets, as well as possible losses on sovereign debt classified as trading assets on banks’ balance sheets.

Truth in Labeling

The trick is that the bulk of the banks’ sovereign-debt holdings aren’t labeled as trading assets. Instead they are part of what the regulators call “banking book” assets, meaning they are valued on the assumption that the bonds will be held until they mature and the banks will be paid in full. Trading assets, by contrast, must be marked to market values each quarter with changes flowing through to profits and losses.

The European Banking Authority’s stress tests aren’t requiring banks to take haircuts on their banking-book assets --you know, things like Greek or Portuguese bonds, which no one believes are worth anywhere near face value. Some banks surely will be deemed healthier than they really are. Investors can read the disclosures and judge for themselves.

Even this is more than some bankers can stomach. “Given the tense situation which already exists in money and capital markets, we believe publishing the results with the present level of detail would exacerbate the sovereign-debt crisis,”the ZKA Central Credit Committee, representing Germany’s
banking associations, wrote in a letter obtained by Bloomberg News.

“To avoid further capital market turmoil, which would fly totally in the face of what the stress test was actually intended to achieve, we believe the level of detail needs to be significantly reduced.”

Start Wondering

To the German bankers’ point, you do have to wonder what the banking authority is trying to accomplish here. When the U.S. conducted its stress tests of large banks in 2009, the goal was to restore investor confidence so they could raise capital again. Although the U.S. tests were widely criticized at the time as too soft, they did succeed in that crucial respect.

In Europe, the data in the sovereign-debt disclosures could wind up undermining the credibility of the test results. Think about it: How’s it going to look if a bank passes with flying colors, even though the disclosures about its bond portfolio make it obvious that the bank is insolvent? If the regulators believe the information is important, shouldn’t they be factoring all of it into their test results? And if they don’t think it matters, why are they releasing it publicly?

This isn’t an argument against the additional disclosures. Transparency for its own sake is a public good. The problem with the stress tests is they don’t go far enough.

Relegating the rot on a lender’s balance sheet to the equivalent of a footnote doesn’t make the bank stronger. Instead the exercise demonstrates that Europe’s leaders still lack the political will to fully address the region’s debt problems. The sooner they come to grips with reality, the better.