The European Capital Test

In the middle of 2010, Europe’s bankers underwent a stress test to determine the assortment of their capital holdings and to what degree they relied on resources connected to problematic states. In spite of the results of the stress test being positive in the beginning, it was found after a while that there were important omissions of details in the test templates. The E.U. banks’ capital structure makes them indeed subject to more risk than is considered healthy.

A few weeks ago, in July 2010, a stress test was imposed on all European banks to determine whether they were ready to survive a future financial downturn. This assessment was chiefly aimed at assessing the EU banks’ reserve levels and its type – whether a satisfactory level of reserves exists and whether it is of a satisfactory quality for the examined banks to rely on. Several countries outside the E.U. introduced a test on their banks’ reserve ratios as well – LSM Insurance informed its followers and clients about that earlier this year as well. The E.U. test discovered that a handful of banks (especially in Greece) were in an unfavourable position, but the the findings in general helped to solidify the investor confidence in the European banking system in general. For those reasons, the Euro and other EU currencies outside the monetary union were benefiting from an unshaken position in the international market.

That is to say for a tad more than four weeks. Early in September 2010, The Wall Street Journal released a detailed analysis of the test results and compared it to a review of the official financial reports of the examined banks. WSJ found that the test subjects often did not manage to detail all the necessary descriptions on their funding, seeing as the numbers could not be entirely matched their statutory reports. This way, the transparency of the input details was unfortunately affected. The banks did not lie. Rather, the banks just did not care to categorize their holdings correctly as the CEBS guidance was not written clearly enough either to start with.

Traditionally, government debentures are believed to be carrying no risk. Considering the financial distress in in Greece, however, they have gained on importance. Greece’s near-bankrupt status puts riskier government debentures and as such, the Greek government bonds ought to be recorded differently. Many banks just would not make this principle clear when reporting. Some banks wouldn’t report parts of their capital holdings, claiming that it was because of their volatility and the fact that they were actively traded in the normal course of their business. This way, they effectively improved their results in an uncontrollable fashion. Since every tested participant “understood” the requirements of the test with slight differences, each tested subject disclosed its reserve holdings differently and that caused that the results are drawing from different assumptions. Therefore, they are virtually incomparable.

In short, the paramount issue with the testing was the limited amount of extra information that the banks included for the regulators. Obviously, the CEBS test requirements were too relaxed to really oblige the banks to reveal any useful pieces of data. This is unfortunate for the Euro, which experienced a severe shock and has been trying to climb back up insecurely from that time forth. It is bewildering to see that even now, the CEBS is still confident with the original rules.

We certainly hope the CEBS and other banking regulators all over the globe are going to learn out of this slip and will take care that any other tests and regulations are well-thought through. Any more issues would harm the trustworthiness of the affected economy.