European stress tests not so important

On Friday, the EU released the results of the European bank stress test. This stress test has been in the news for a little while now as experts and investors were waiting what the outcome would be. You may remember the term ‘stress test’ being used a lot a little over a year ago because that’s when the United States conducted it on their banks. After the U.S. released their stress test results, the effect on the banking system and overall economy was positive and injected some confidence in to the system. For this reason, Europe thought it would be a good idea to conduct a similar test for their banks.

The European test looked at 91 banks and checked to see how they would fair in another recession. Out of the 91 banks, only 7 failed and of those 7, you probably only heard of 3 of them, at the most. Those 3 banks are: Germany’s Hypo Real Estate Holding AG, Greece’s ATEbank and Spain’s Cajasur. All three of the banks I just mentioned already received government funding to stay afloat. The remaining 4 banks are also from Spain but are small and fairly insignificant.

Although the results of the stress test are positive, there is a lot of scrutiny about how they were conducted and what they actually checked for. The test looked at how the banks would fair during another recession, however this is exactly where they made a mistake. Right now, the biggest threat of a European recession is from the possibility of Greece defaulting on its massive debt. The problem is that the stress test did not even look at this scenario at all, making it a much easier test to pass.

The second major factor for the criticism comes from the fact that this stress test was a lot less organized than the U.S. stress test a year ago. This is not the test’s fault, but rather the European banking system whereby each country has its own standards and formats. Unlike the U.S. where everything comes from the top and everyone plays by the same standards and rules, in Europe every country dictates their own standards and this makes comparing banks much harder to do. In addition, the flow of information about all these banks is not to the level as it is in the U.S. and since the standards are different, you may not even have the same types of information from all the banks.

It seems unlikely that these tests will have a negative effect, which is always good, but the chance for a meaningful positive effect is not very high either. It is unlikely that this stress test will yield as much positives for the European (and thus, global) economy as the U.S. stress test did for North America last year, but I guess it is still better than nothing. It does raise the question however, that maybe they knew that if they included a scenario where Greece defaults on its debt then many banks would fail? We don’t know that this is the case, so maybe it’s better not to think about that. All we know is if for some reason, we entered another recession that did not involve any country defaulting on its debt, the European banking system would be ok. Unfortunately, if another recession in Europe does occur, it is unlikely that Greece and maybe some other nations would be spared.