ECB Stress Test Stresses Out Major Banks

The European Central Bank will assume supervision of the eurozone's largest lenders in November. But before that, the ECB is putting banks through their paces. The results of its stress test are to be announced Sunday.

As if the eurozone wasn't experiencing enough stress already. Recent economic data have been weak, debt levels are on the rise and unemployment is high. Plus the bloc's central bank is under fire for its monetary policy.



The ECB, for its part, is subjecting 130 banks in the euro area to a stress test. The moment of truth will come Sunday, Oct. 26. Rumors of shaky banks are already prevalent and there is speculation about financial market turbulence the day after.



The fact that the ECB is heaping that sort of stress on itself and large eurozone lenders has to do with the much-debated banking union agreed upon at one of the bloc's crisis meetings back in June 2012. That union was to break the vicious circle of banking crises causing state crises, thus doing away with a fundamental flaw in the single-currency area.



The union will be based on three pillars - supervision, a winding down mechanism for failing banks and deposit protection.



After much hubbub, agreement was reached last year on how to wind down failing banks. Joint deposit protections will also become a reality, at which point the banking union will metamorphose into a kind of insurance. And to make sure no bank joins that union in an unacceptably poor state, German economists and others have been strongly in favor of vetting candidates before the ECB starts its supervisory function.







"Those wanting to join the supervision scheme will have to qualify for it and prove that they don't pose a high risk for all the others," Hans-Peter Burghof from Hohenheim University told DW.



This will also be in the interest of the ECB, Burghof added, noting that the bank does not want to assume liability for old risks.



The test is about banks' core capital ratios, which have to amount to at least 8 percent of a lender's risk-weighted assets. This, in turn, means that debtor-risk assets are only partly considered in the equation.



Questionable data?



But there is one caveat, said Clemens Fuest, president of the Center for European Economic Research (ZEW).



"The relevant assessments are being partly made by the banks themselves," Fuest said. "Experience based on the financial crisis has shown that a risk-weighted core capital ratio is not the best of indicators for a lender's health."



"Those risk models tend to work in past data, and it's not really clear that crises of the future can be headed off with such an approach," he added.



Fuest argued it would be better to make banks finance at least 3 percent of their overall assets through their core capital, speaking of the so-called leverage ratio. A stress test conducted by Fuest's own think tank has shown that capital needs can be gauged more precisely when incorporating the leverage ratio instrument.



ZEW experts believe that normally banks would be able to meet core capital requirements based on the ECB's risk-weighted assets model. Fuest has said lenders must simply build up their assets for this purpose without using fresh external money.



"We can even show that the 10 largest banks' core capital has decreased in absolute terms, and they've further reduced their lending activities and investments to make the core capital ratio go up," Fuest said.



This underscores the dilemma facing the ECB at the moment. On the one hand, it practically gives away money to banks for them to increase lending to companies and fuel growth. On the other hand, it is a regulator and, as such, calls on banks to raise their core capital in order to make them less vulnerable in crisis situations.



But are the lenders really prepared for the next crisis? This is crucial when it comes to the current stress test. The ZEW institute claims the lenders are not prepared well enough. It says that a 10-percent drop in the value of assets held by the banks would already leave them with an overall capital gap of 150 billion euros ($190 billion). German and French banks would find themselves in a bind in this scenario - which is not overly pessimistic.



Which assessment the large lenders will get from the ECB will to a large extent depend on the central bank's underlying crisis scenarios.



Finance expert Hans-Peter Burghof does not like the idea of applying different crisis scenarios for different nations.



"German banks are being subjected to tougher scenarios than Greek banks," Burghof said.



Much ado about nothing?



Thomas Hartmann-Wendels from Cologne University said it is also a political issue.



"The ECB is unlikely to say Greece is bankrupt and needs another haircut," Hartmann-Wendels said. "If the applied scenarios are too much on the tough side, the results of the ECB stress test would cause massive unrest on financial markets."



"But if the scenarios are too soft, the value of the test would be rather limited, leaving the ECB's credibility dented," he added.



Nonetheless, Hartmann-Wendels thinks such tests are not completely irrelevant.



"Only, the results shouldn't be overrated and people shouldn't make such a fuss about them," he said.