Posted by:
Andrew Bell

15 July 2010

On that quintessentially French holiday, when they celebrate the anniversary of a thoroughly good riot in 1789, leading to a stress test of the French monarchy and the storming of the hated Bastille to release prisoners who had fallen foul of the King, we look forward to the stress tests planned to demonstrate the durability of the European banking system, due for release by the 23^rd of July.

A former Chinese premier Zhou En Lai, when asked about the historical significance of the French Revolution is reported to have said (in 1971) that it was “too soon to say”. The significance of those earlier events may now be largely symbolic (only 7 prisoners were released), as France still has elitist and monarchical tendencies in its government and Presidency, for all the official egalitarianism. For the French national psyche, however, the price was undoubtedly (as L’Oreal might say) “Woerth it”, despite the unintended consequences (sparking 25 years of pan-European war). Perhaps their love of state-financed infrastructure was born from the desire to have enough lamp posts from which to string up the dispossessed blue bloods.

It remains to be seen whether the imminent stress tests for Europe’s banks (coming over a year after a similar exercise cleared the air for the US sector) will see the agony of waiting give way to the ecstasy of passing. If the tests are insufficiently negative about the possible loss percentages on less esteemed European sovereign credits or the downside risks for economic growth, there is a risk of their failing to clear the air, instead filling it with unanswered questions.

Of course, it is widely believed that some European banks have unsustainably weak balance sheets and will either need to ration credit more tightly (not viewed as a good thing when one is trying to kindle an economic recovery) or raise additional equity.  The recent European sovereign debt crisis (like the US housing losses in 2006-9) may have merely catalysed the “outing” of the halt and the lame in the financial sector. Addressing their problems cannot be swept under the carpet because investors have asked a question (about sovereign creditworthiness) for which there is not yet a convincing answer, given the scale of economic sacrifice needed by some weaker countries and the reluctance of Germany to give them a soft landing, for the sake of the common wealth.

However, aside from the need to marginalise or recapitalise weak institutions, the main issue for the other banks is not the credibility of the stress tests but the confidence of investors that the “stress case” scenarios will not happen. Has anyone stopped to consider how wasteful it would be if all banks had enough capital to withstand years of recession, plunging employment and collapsed asset values? A genuinely worst case stress test could only be weathered if there were ludicrous wasted capacity in the banking sector, rather like the UK government issuing each street with a snow plough to cope with the 1 winter in 20 that leads to a few days travel disruption. It would be better to accept some risk and devote more resources to counter-cyclical planning and to forecasting.

So, it will be relatively unimportant if the stress tests (while erring on the pessimistic side of realistic) are not viewed as incontrovertibly worst case. The key issues are that a mechanism should exist to repair, support or wind down any institutions that fail and that there is a clear official commitment to promote economic growth, in order that investors can sensibly ignore the worst case possibilities. Without growth, the number of countries, companies, individuals and banks in trouble will multiply. With sustained growth (even if at levels that disappoint compared with past cycles) the number of casualties will be restricted to the genuinely morbid - a flu outbreak not the Black Death.

Although the risk of the European authorities again mismanaging economic confidence cannot be dismissed, it seems probable that the stress testing, together with the conditional aid announced for Club Med governments, is designed to assuage fears, keep growth improving and reduce the number of genuine problem cases so that they can be managed without contagion to others. If this happens, the tentative equity revival since the start of July should have further to go, since ratings look undemanding if you believe the earnings and dividend numbers.

Longer-term, it would be rational for regulators to impose higher capital requirements for the banks, as well as engaging more actively in supervising the collective economic drunkenness that characterises credit booms. In that way, the risks of major financial failure should be reduced and the buffer to absorb accidents will be greater. However, trying to impose that in short order would either involve the banks shrinking to fit the tighter regime or significant extra savings being diverted to strengthen bank capital. Neither is ideal given the necessity of sustaining positive economic growth in order to make the debt burden manageable. What is needed is a controlled weight gain by the banks (with more of their retained earnings being salted away for that future rainy day) arising from a benign feedback cycle of recovering lending spurring stronger collateral values and employment levels. Trying to turn the sector from an anorexic duck into a Strasbourg goose overnight, as a result of a “chicken licken” stress test is likely to result in a bigger bill than improving financial living conditions and adopting coherent and consistent methods of economic husbandry, focused on growth.

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

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