Posted by:
Andrew Bell

26 July 2010

The reason the European Union resolved to carry out stress tests on their banks was their exposure to the sovereign debt of Eurozone member countries and the presumption that, in pursuit of yield, this exposure was disproportionately invested in the bonds of countries whose deficit positions have prompted most anxiety in the markets this year (the so called PIIGS). Of these, Greece is generally agreed to have the most troubling mix of debt burden, structural economic issues and national unwillingness to address the problems. The principle behind the reluctant supply by other countries of funds to help Greece was that non-Greek banks had significant exposure to Greek bonds or those of other countries (notably Spain) which were more economically significant than Greece and at risk of being viewed as next in line if Greece were to default. So, a significant part of the focus of the stress tests was that the banks would disclose their country by country exposure to Eurozone sovereign debt.

The German banks, all but one of which passed the tests, did not disclose this breakdown. This is a significant omission that feeds the conspiracy theories that parts of the Eurozone would rather cover up their adverse asset exposures than reveal them and recapitalise the banks accordingly. If the implicit state guarantee behind the German Landesbanken is viewed as solid and the economic recovery across Europe (which accelerated this spring before the second quarter’s financial wobbles) remains secure, this may be tenable, although it seems likely that there will be a cost of funding/capital benefit for banks that do disclose.

The other technical wrinkle is that bonds held for trading have to see price changes reflected through the profit and loss account whereas bonds held to maturity do not (unless impaired, from which sovereign bonds have been by definition viewed as immune). So, discounted prices of Greek debt would not be reflected as capital “hits” if held on the non-trading books (which is probably where most of them have ended up). Similarly, if (for example) Greek bonds with 6% coupons and 10 year maturity (current price 73%) were forcibly replaced with 100 year bonds yielding 1% (a structure which would restore solvency, though not credibility, to Greek finances) some accounting regimes might allow a hold to maturity bond to be carried at par even though in present value terms it had been devalued. This would clearly be fictional. When Wall Street described former US Vice President Dan Quayle as like a zero coupon perpetual bond (offering neither interest nor maturity) it was a political comment that could be shrugged off, but the absence of financial credibility is a telling problem for the banks. The state of sovereign credit in Europe will remain a hot potatoe. Disclosure is necessary to allow investors to do their own sums, even if bank accounting rules allow the rocks beneath to be hidden below the unruffled surface of the tier 1 capital ratio.

There remains work to do if the market is to believe that problems are confined to the small number of banks around Europe that failed, along with some of the Spanish “Cacas”. Sustaining the tolerant initial market reaction will be dependent on the recent improved economic growth figures continuing. From that point of view, the stress tests are not particularly rigorous, although arguably the risk of prolonged recession is lower than when the US banks were more stringently tested in early summer 2009. Taking account of intervening capital raising and retained profits, the European authorities may be able to convince the markets that, in general, their banks are sound, as long as the official commitment to maintaining orderly sovereign debt and credit markets remains. Consequently, the European bank stress tests are neither fated nor to be feted.

Argument continues to rage over whether the rally in government bond markets since April (at least those not under suspicion) should be given respect as forecasting recession or simply viewed as the obverse of a “risk-off” trade in financial markets that were then ripe for profit taking. Having lived through a period of softening data and a correction in risk assets that appeared to have run ahead of the deterioration in forecasts, the balance of sentiment may be swinging in favour of a continuing, albeit variable recovery, rather than extrapolating the slowdown in growth to predict a second recession. There are, after all, benefits to economic confidence from the reduced expectations about future borrowing costs (rates lower for longer) and higher quality corporate bond yields are close to 10 year lows.  Whilst financial markets have traditionally been viewed as (frenetic and unreliable) predictors of the economic outlook, at present they appear to be more than usually part of the forecast and not simply bystanders. The weak state of the western banking system places more reliance on the financial markets’ ability to deliver finance to the corporate sector and to contribute to any convalescence in economic confidence.

Strength in asset prices in the absence of significant monetary growth depends upon confidence. If confidence falls, weaker equity prices make it harder for companies to raise funds, increase pension fund deficits (creating a further drain on corporate cash flows) and deflate the spending ambitions of those with significant financial assets (those whose marginal income tax rates are currently rising). Weakened confidence in the economy rubs off on the banks, increasing their cost of funds and reducing loan supply for the corporate and housing sectors. So, more than usually, negative trends in financial markets have the capacity to cause economic growth forecasts to decline rather than simply repricing to reflect changing forecasts. There is therefore likely to be a public policy bias in favour of sustaining orderly financial markets, in order to support the gradual improvement in economic growth that will be needed over many years to accommodate the reduction in debt burdens and bring national budget deficits under control.

This bias is not a “get out of jail free” card for investors, because there is a risk of policy errors and the path of asset prices will be erratic. However, it may help underpin confidence in the medium-term direction of asset prices and reduce the risk of assets becoming unreasonably (and potentially damagingly) cheap. Let us hope so.

Comments or feedback are always welcome at theblog@witan.co.uk.

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