What the European Central Bank’s Stress Tests Revealed about Europe’s Economic Recovery

Is something rotten in the state of Europe? Cynical economists and financial analysts might certainly find significance in the prophetic lines from Shakespeare’s Hamlet – albeit the twenty-first century, European Union-friendly version – after 130 of the Eurozone’s largest banks underwent ‘stress tests,’ the results of which were released by the European Central Bank (ECB) on 26 October 2014. Although the tests discouragingly exposed twenty-five ‘rotten’ banks out of the 130 institutions assessed, the ECB declared the tests to be the most comprehensive assessment to date, a positive sign for the eighteen countries in the Eurozone after several years of economic instability. Despite the continued presence of minor ‘rotten’ components within the Eurozone, the ECB’s ‘stress tests’ largely contribute to the region’s economic recovery, as they constitute a comprehensive and thorough first step of the ECB’s extensive economic mobilisation policies.

Image courtesy of mathrong © 2011, some rights reserved
Image courtesy of mathrong © 2011, some rights reserved

Officially – and aptly – known as the Comprehensive Assessment, the ECB’s exercise included both an asset quality review (AQR), and ‘stress tests’ across 19 countries, 130 banks, and 81.6 per cent of the total banking assets within the Eurozone.[1] The AQR targeted banks’ capital ratio, which compares the degree to which banks rely on stable cash flows, such as shareholder funds, against the amount of weaker forms of capital, such as loans and borrowed money, on any given bank’s balance sheet. Using the AQR data, the ECB then conducted quantitative stress tests that probed banks’ solvency under both ‘baseline scenario’ criteria and a range of ‘worst-case scenario’ criteria in order to gauge the stability of the European financial system in a hypothetical economic recession lasting from 2014 to 2016.[2] The worst-case scenario, regarded to be the most rigorous component of the exercise, exposed that Eurozone banks would have a €24.6 billion overall shortfall, while twenty-five banks would fall into insolvency with a capital ratio of less than 5.5 per cent in a hypothetical economic downturn.[3] Although the number of hypothetically failing banks fell largely within economists’ expectations, European politicians will surely heed the problematic sign that the failing banks were largely located in a cluster of southern and peripheral countries of the Eurozone; Cyprus, Greece, Italy, and Slovenia accounted for seventeen out of the twenty-five troubled banks, which comprised of approximately 84.2 per cent of the overall shortfall. Meanwhile, Belgium accounted for two rotten banks, while Portugal, Ireland, Austria, Germany, France, and Spain accounted for one troubled bank each.

At face value, the data seem grim. Yet upon further review, there is good reason to believe in ECB’s methods that exposed the banks’ balance sheets. Exposed, however, is the key word; it signals the ECB’s intent to create transparency between the banks, investors, and the greater public in order to stimulate confidence in Europe’s financial institutions. By creating this transparency, the ECB aims to achieve two primary objectives: first, separating the healthy banks from the unhealthy banks will prompt more overall investment because before the Comprehensive Assessment, investors had unclear data on all of the Eurozone’s banks and thus were more skeptical of investing in any of the banks.[4] Second, by releasing the results of the ‘stress tests’ the ECB greatly incentivises unhealthy and even moderately healthy banks to strengthen their capital ratio, a initiative that will ultimately prompt banks to become more stable, and to lend more money to businesses and individuals with the intended result of stimulating the economy by indirectly increasing money lending.[5] Tellingly, Banca Monte dei Paschi di Siena S.p.A., the Italian bank with the largest ‘worst-case scenario’ shortfall at €4.3 billion, hired Citigroup and UBS as consultants to develop strategies to substantially increase its capital immediately after the ECB released the results of the stress tests, which was duly covered by much media attention. Although the benefits of the stress tests are certain to have a greater long-term impact than immediate effect, the Eurostoxx50 index, one of the primary super-sector indices in the Eurozone, nevertheless posted a modest 1.77 per cent gain on the week from 27 October to 31 October. As a whole, the ECB’s Comprehensive Assessment represents a valuable initiative to provide clarity in the wake of the height of the Eurozone crisis from 2009 to 2011, and to uncover weaknesses within the system in order to understand how to remedy them.

Further evidence exists to corroborate the scope and depth of the ECB’s assessment. On 4 November 2014, the ECB will assume new powers to regulate the Eurozone’s economy, including the Single Supervisory Mechanism (SSM), which gives direct oversight over the 130 largest banks – the same 130 that underwent the stress tests – to the ECB rather than regulatory bodies in individual countries. Indeed, this gives the ECB a strong incentive to put the 130 banks under the most rigorous assessment to date. Unlike the 2011 European Union-wide stress tests administered by the European Banking Authority (EBA), which were widely regarded as less thorough and less effective, the 2014 ECB-administered exercise has clear interests to intimately fathom the individual advantages and risks of the 130 largest banks in the Eurozone as the ECB prepares to administer oversight over them.[6] Furthermore, the ECB has placed its credibility as an institution on the accuracy of its Comprehensive Assessment as it seeks to wield its expanded powers to establish the stability and equality across the Eurozone.[7] Transcending the variation in economic scale and geography will be crucial to the ECB’s success; hypothetically, it must assure Italian banks are well regulated before Germany agrees to bail them out, for example.[8]

Simultaneous political and economic bureaucratic change within the E.U. and Eurozone will optimistically accentuate the ECB’s progress. Only days before the ECB is due to assume greater financial oversight on November 4th, on 1 November 2014 the new European Commission, led by Luxembourgish Jean Claude-Juncker and supported by 27 other commissioners, assumed their positions in the most influential E.U. political institution. Juncker, himself an advocate for the deepening of E.U. integration, combined with the ECB’s expanding powers, represent a new stage in E.U. integration. Both governing bodies must establish credibility and trust; for the first time, the president of the European Commission was democratically elected by the European Parliament, leaving Juncker to uphold policies to a high degree of popular accountability. As with the public, new politicians from Germany to Greece will surely expect positive economic signals over the next few years. Indisputably, rather than for Germany, France, Italy, and so forth, to work in opposite directions, the way forward for Europe is through fluid cooperation between member states to encourage economic growth. In tandem, as the ECB exercises its expanded authority, the stress tests must simply be the first step in the ECB’s wide-reaching plan to stimulate the region’s economy. In this new era of European integration, there is certainly reason to hope that, led by the ECB and supported by politicians in the European Commission, the Eurozone will regain extensive economic prosperity and achieve its aim of uniting Europe on a grand scale.

[1] http://www.ecb.europa.eu/pub/pdf/other/aggregatereportonthecomprehensiveassessment201410.en.pdf, p. 12

[2] Ibid. p. 14.

[3] http://graphics.wsj.com/european-stress-tests-2014/#co-operative-central-bank-ltd

[4] http://www.spiegel.de/international/business/stress-tests-in-europe-interview-with-mohamed-el-erian-a-998612.html

[5] Ibid.

[6] http://dealbook.nytimes.com/2014/10/27/e-c-b-stress-tests-seen-as-bolstering-confidence-in-banks/?_r=0

[7] http://www.economist.com/news/business-and-finance/21628422-europes-banks-have-been-probed-some-have-been-found-wanting-who-stressful-tests

[8] Ibid.

Leave a Reply