Sunday, November 02, 2014

ECB stress tests and Europe's fatal politics

"Europe suffers from fatal politics." - Joseph Stiglitz, August 2014

Gretchen Morgenson presents a report on the ECB bank stress tests, Cracks in the Stress Tests of European Banks New York Times 11/01/2014. She stresses the seriousness of the findings, and how important future financial supervision is to maintaining the banks' integrity:

A crucial aspect of the examination was an analysis of how each bank valued its assets, such as loans and interest-rate swaps and other derivatives holdings.

The derivatives holdings on these institutions’ books total hundreds of billions of euros. So it’s critical that banks accurately assess the risks that arise in these holdings when a trading partner gets into financial trouble. (This assessment is called a credit value adjustment.)

The analysis was discomfiting. The European Central Bank concluded that fully half of the sampled banks had inadequate practices when it came to calculating and adjusting their holdings for credit risks associated with derivatives trading partners.
She doesn't comment on the politically convenient aspect of the ECB stress test findings, which is that most of the problems they identified were in eurozone "periphery" countries like Italy.

And she doesn't mention the largr point emphasized by Wolfgang Münchau, which is that it's not the availability of credit that's keeping the eurozone in depression, it's deficient economic demand.

Martin Wolf looks at the stress tests in Europe’s banks are too feeble to spur growth Europe’s banks are too feeble to spur growth Financial Times 10/28/2104:

The optimistic assessment is that the ECB has at least done enough to mend the banking system. There are two things to be said for this judgment: first, the ECB has taken a close look at the quality of assets in the system; and, second, the “stresses” imposed in the tests are tough. They seem comparable to those imposed by the Federal Reserve on US banks. The ECB concluded that 25 institutions, nine of them Italian, would need to add a total of €25bn in capital. This number has already fallen to €13bn because of capital-raising undertaken this year.
Of course, it's a bit of damning by mild praise to say that the ECB stress tests "seem comparable to those imposed by the Federal Reserve on US banks." They also drew criticism from some economists for being excessively permissive.

Wolf proceeds to point out a non-trivial deficiency in the ECB stress tests:

Perhaps the most important possibility omitted by this assessment is that of sovereign default. This bears on a fundamental concern: risk-weighted capital requirements, on which the analysis is based, involve making judgments about the safety of different types of assets. This is especially problematic in the eurozone, where the lack of a unified fiscal backstop for banks means that national governments are responsible for rescuing troubled institutions. Moreover, the solvency of the eurozone’s highly indebted members is more doubtful than that of countries with their own currencies. Since a banking crisis would be even harder to deal with in the eurozone than elsewhere, it would be wise for its banks to have bigger capital buffers that stand a better chance of preventing one.
And he echoes Münchau's macroeconomic warning:

... one must doubt whether the capital in eurozone banks is enough to drive the economy forward. But this is just one part of a still bigger problem: the dramatic weakness of aggregate demand and the slow slide into ultra-low inflation and, quite possibly, deflation. Sounder banks do not necessarily generate faster growth in demand. Indeed, causality goes far more in the opposite direction. [my emphasis]
And the prospects for that are grim, thanks to the Herbert Hoover/Heinrich Brüning that Angela Merkel and her junior coalition partners in the SPD have agreed for years to impose on the eurozone. Joe Stiglitz wasn't kidding. "Europe suffers from fatal politics."

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