Will European stress tests boost U.S. financial firms confidence?

July 23, 2010
Will European stress tests boost U.S. confidence?
By Kevin G. Hall | McClatchy Newspapers

WASHINGTON — Stress tests on European banks, released Friday, concluded that only seven of 91 major European financial firms need to raise additional capital, but the results raised more questions for U.S. analysts than they answered.

Taking a cue from a similar U.S. confidence-building measure last year, European regulators subjected bank balance sheets to stress testing to gauge how they'd perform if much of Europe slid back into recession and financial markets plunged.

The Committee of European Banking Supervisors reported that five Spanish banks, a Greek bank and a German bank lack sufficient capital to survive a sharp downturn. The seven were ordered to raise a total of 3.5 billion euros (about $4.5 billion) in additional capital.

The health of banks in Europe matters to ordinary Americans. A growing debt crisis in the so-called PIIGS nations — Portugal, Ireland, Italy, Greece and Spain — has roiled U.S. financial markets, ending a yearlong rebound in stock prices. The volatility has hurt the 401(k) plans and individual retirement accounts of American workers and savers.

The return of volatility to global stock markets also has been one of several factors that are hampering the U.S. economic recovery.

In Europe, 7.7 percent of 91 banks need to raise additional capital, far better than the results of last year's stress tests in the United States, after which 10 of the 19 largest banks, or 52.65 percent, were ordered to raise a total of $74.6 billion. Bank of America, at almost $34 billion, accounted for almost half of that needed capital cushion.

However, regulators in Europe, like their American counterparts, allowed banks to hide many of their biggest potential liabilities from the stress tests.

The U.S. stress testing allowed banks to understate potential losses from the hold-to-maturity housing bonds that made up most of the toxic assets polluting their balance sheets.

In Europe this week, regulators also focused on trading books, which contained a fraction of their hold-to-maturity sovereign debt — the bonds issued by governments, particularly indebted ones such as Spain and Greece that are at risk of default.

Only one Greek bank failed the stress test, although most economic analysts think Greece is insolvent and will need to restructure its debt, even after a $142 billion European bailout. That undermined the credibility of Europe's stress tests.

"The point is, we're not out of the woods yet, they didn't address that. One has to say that's a big problem out there that somehow is going to have to be dealt with," said Nariman Behravesh, the chief economist for forecaster IHS Global Insight.

Asked why the government bonds weren't counted in the stress testing, the chairman of the banking supervisory committee, Giovanni Carosio, told CNBC television that such losses could be counted only in the event of a default, adding that Europe has erected a $1 trillion backstop to prevent defaults. He also defended the tests.

"The scenarios we used were extremely severe, even implausible events, actually," Carosio said.

The results came at the close of trading on European markets, so the first real gauge will arrive Monday. Stocks in the United States largely flat-lined after the results were released, rising late in the day on other news.

Vincent Reinhart, a former top economist at the Federal Reserve, likened the European stress tests to a professor creating an easy exam with a tough grading system.

"The main goal was to reframe investors' expectation or focus away from the bad decisions banks made in the past to the fact that they can be profitable going forward," Reinhart said. "The big issue is what hidden valuation of assets do they have on their balance sheets? What we just learned is banking is basically a profitable business . . . but what we didn't learn is how much have those institutions dealt with legacy losses? What is the stuff still hidden on their balance sheets?"

Although European banks performed better in the stress testing than U.S. banks did last year, the U.S. testing came amid a deep financial crisis. European regulators have had almost two years since the near-meltdown of U.S. financial markets in September 2008 to pump capital into banks.

In both Europe and the United States, banks were loaned capital to boost their reserves in case further losses followed. The U.S. effort was hugely unpopular with citizens, but the banks have paid back most of the money and Treasury Secretary Timothy Geithner said Thursday that taxpayers had made about $20 billion so far on their stakes in U.S. banks.

The Treasury Department announced Friday that it would sell another 1.5 billion shares of Citibank stock in the next two months. It already has sold 2.6 billion of the 7.7 billion shares taxpayers acquired as part of a $45 billion bailout of Citibank.

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