5 Lessons of European Bank Stress Tests

It's not all bad news!

Banks across the European Union underwent stress tests on Friday as a means of evaluating the extent of the financial crisis still affecting much of the EU economy. Now that the banks, the European states, and the markets have had a chance to respond, observers are getting a clearer sense of what the tests reveal. Here are five lessons learned.

• Hint of Optimism Amid Widespread Uncertainty  The Wall Street Journal's Neil Shah reports, "Investors hoping for a quick-and-easy verdict on Friday’s European bank stress test results by the markets are likely to be disappointed. But while the market’s snow-globe is cloudy, one can see glimmers of optimism. The question is: Is this all we’re going to get? Whether it’s European stocks, government bonds or the value of the euro, financial markets in Europe are mostly in wait-and-see mode Monday, though there are green shoots of positivity."

• EU Unlikely to Let States Default  CNBC's Vince Farrell speculates, "The whole point of the test was to see if the bank(s) could survive a sovereign default. That never came up. What was (inadequately) measured was the haircut sovereign bonds would take if times turned bad. ... To repeat, the panic in the market that brought about the demand for the stress test was the fear of a country going belly up. What this test is effectively saying is that the EU will not allow a country to fail. Ok, maybe it'll work for one country. But what if two, or more, are threatened? There aren't enough Euros to go around."

• Greek Default Threat Still Unaddressed  The Financial Times' Wolfgang Munchau warns, "the pricing of Greek bonds already implies a non-trivial probability of a default – and that would affect both books. Certainly, the stress tests should be based on what one might call a plausible worst-case scenario, not one that represents the absolute worst. Nobody is asking the bank supervisors to stress-test the impact of an alien attack. But sovereign default in the case of Greece is not such a far-fetched scenario – even if you believe it to be unlikely. It is irresponsible for the stress testers to ignore that sort of event. That is like a car crash tester failing to consider the possibility of an oncoming vehicle."

• Spain Grim but Rallying  The Dow Jones Newswire's Christopher Bjork writes, "The Spanish banking sector, which was the hardest hit by the EU-wide stress test Friday, staged an early relief rally Monday along with other European banks, as investors welcomed fairly rigorous tests, even though they failed to uncover the capital shortfall that many market participants had called for. ... Analysts in Spain said the test results were supportive for the country's two biggest lenders."

• The Politics of EU Stress Tests  Matthew Yglesias translates:

The real meaning of “stress tests,” however, seems to me to be a mechanism for politicians to offer guarantees to banks while pretending that’s not what they’re doing. After all, when a bank regulator says a given bank has passed a stress test that means in effect that the regulator is saying that for him to let that bank fail would require him to admit to having made a mistake. And since powerful people these days never seem to admit to having made mistakes, that amounts to a guarantee. Then the hope is that this covert guarantee will allow the bank to recapitalize itself through earnings, thus avoiding politically unpopular direct appropriations and the dilution of incumbent equity owners’ holdings.