European Banking Stress Test: Much Ado about Nothing

On Friday the Committee of European Banking Supervisors (CEBS) revealed the results of its banking sector stress test. The objective of the test, in the CEBS’s dry words, was to “provide policy information for assessing the resilience of the EU banking system to possible adverse economic developments and to assess the ability of banks ( … ) to absorb possible shocks on credit and market risks, including sovereign risks.”

The test covered 91 European banks from 20 European Union member states, which represented 65 percent of the total assets of the EU banking sector. And it included two scenarios:

A Benchmark Scenario and
an Adverse Scenario

The benchmark scenario assumed a mild economic recovery for the whole European Union with GDP growth of 1.0 percent in 2010 and 1.7 percent in 2011. The adverse scenario covered a double-dip recession with GDP staying flat in 2010 and declining 0.4 percent in 2011.

The adverse scenario additionally envisioned what the bureaucrats call an “EU-specific shock to the yield-curve, originating from a postulated aggravation of the sovereign debt crisis.” They assumed three-month rates rising 125 basis points (1.25 percent) and 10-year rates rising 75 basis points (0.75 percent).

Only seven banks failed the test. Two of the banks had already been nationalized: Germany’s Hypo Real Estate (HRE) and the Agricultural Bank (ATE) in Greece. In addition, five Spanish banks failed.

But it’s no surprise to me that the remaining 84 banks emerged unscathed, because …

The Adverse Scenario Ignored
the Biggest Threat of All!

The adverse scenario was nothing more than a relatively harmless double-dip recession and moderately rising interest rates. Most notable: Not a single word about what would happen if a European country defaulted on its debt.

The possibility of a sovereign debt default never entered the picture.

Yet wasn’t a possible Greek default the spark that ignited the whole European crisis? So why in the world didn’t the CEBS toss a sovereign debt default into the equation?

I’ll tell you why …

The European stress tests were modeled after the tests U.S. regulators conducted on 19 top banks back in May 2009. And as in the U.S. this whole stress test topic is nothing more than a propaganda show — at least in my opinion.

Both tests were designed to do no harm, to make passing it a piece of cake. The show’s purpose was to calm the markets and restore the people’s trust in the banking sector.

But that’s not what I see coming around the corner …

My business and stock market cycle model is forecasting another recession and another stock bear market. Specifically it’s predicting two major risks:

First, the world economy will probably not just double-dip, but enter another very severe recession, maybe even a depression.

Why?

The economy’s rebound is the result of the largest government stimulus program in peace times. This means that the old imbalances and problems have never been cured! They’ve just been papered over with newly printed money and government debt.

Now the Fed and the Treasury, as well as other central banks and governments, have much less leeway to react to another blow. Interest rates are already near zero, central banks’ balance sheets are already bloated with questionable toxic debt, and budget deficits have gone through the roof.

If the next recession were to start in a few short months — a real danger here — there are no means left to fight it.

Washington is out of ammo to fight the next recession.

Second, government over-indebtedness is already a major risk. Not just for the governments concerned, but even more so for the holders of their bonds, mainly banks and the insurance sector.

Moreover, another recession now will automatically make all the cheap austerity talk obsolete. Tax revenues will decline, and transfer payments will rise. The result: Higher budget deficits and further deteriorating government finances.

In this scenario, which I deem most probable, we won’t see interest rates rising by a negligible 75 to 125 basis points. No. We’ll have much higher interest rates, and outright government defaults will become unavoidable.

And regardless of the spin surrounding the stress tests, the truth is that not many banks — not in Europe nor in the U.S. — are healthy enough to weather this kind of a storm.

Best wishes,

Claus

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