Banking's Final Exam

Stress Testing and Bank-Capital Reform

Morris Goldstein

• Publisher: Peterson Institute for International Economics
• Year: 2017
• ISBN:
  9780881327069
• Topic: Volkswirtschaftslehre
• Subtopic: Banken & Bankwesen

Spurred by the success of the first stress test of US banks toward the end of the global economic crisis in 2009, stress testing of large financial institutions has become the cornerstone of banking supervision worldwide. The aim of the tests is to determine which banks are adequately capitalized under severe economic shocks and to order corrective measures for those that are vulnerable. In Banking's Final Exam, one of the world's leading experts on banking regulation concludes that the tests administered on both sides of the Atlantic suffer from fundamental weaknesses, leading to a false sense of reassurance about the safety and soundness of the banking system. Some weaknesses can be corrected within the existing bank-capital regime, but others will require bold reforms—including higher minimum capital requirements for the largest and most systemically-important banks. The banking industry is likely to resist these reforms, but this book explains why their objections do not hold water.

1

Why Were the EU-Wide Stress Tests Not Better Received?

There are many explanations for why the EU stress tests generated a less favorable reaction than their US counterparts. Five factors merit emphasis.¹

Weak Supervisory Authority

The organizations coordinating the first three EU-wide stress tests—the Committee of European Banking Supervisors (CEBS) for the 2009 and 2010 tests and the European Banking Authority (EBA) for the 2011 tests—were new EU organizations without much clout vis-à-vis national bank supervisors—the same national supervisors that had slipped up on supervision and capital adequacy before the global economic and financial crisis. The CEBS and EBA had relatively small staffs and resources, no long track record of credibility, limited authority to challenge submitted information on bank assets, and no authority to compel (rather than just recommend) recapitalization if banks participating in the test were found to have capital shortfalls (see Posen and Véron 2014).² These features lie in sharp contrast to the lead agency running the stress tests in the United States, the Federal Reserve.³

No Critical Mass on EU Banking Union, and a More Serious Too Big to Fail Problem

The EU stress tests of 2009–11 were run before a critical mass of opinion had formed on the necessity of establishing an EU banking union.⁴ Even putting aside the single (EU-wide) deposit insurance fund (on which there is still no EU-wide consensus), there was no meeting of minds before June 2012 on either bank resolution or EU-wide funding of bank failures. Even today questions remain about whether the multilayered decision process and small starting size of the common resolution fund would be adequate to address the failure of a cross-border EU bank with trillions of dollars of assets.⁵ Schoenmaker and Véron (2016, 42) conclude that “banking union is only half-finished as an overarching policy framework” and cite the lack of common deposit insurance and a common backstop for the single resolution fund as key unfinished business. Before the 2009 stress test was completed in the United States, the US Treasury had more than $200 billion left from the initial Troubled Asset Relief Program (TARP) legislation that could be used to recapitalize undercapitalized US banks that could not raise the funds from the private markets.⁶

Note, too, that relative to the United States, big EU banks are much larger relative to both home-country and regional GDP, and banking is more important relative to capital markets. Put in other words, the “too big to fail” problem is much worse in the European Union than in the United States (see appendix 1A for a comparison of some popular indicators of too big to fail banks). When funding for bank recapitalization is in question, it is reasonable for investors to worry that estimated capital shortfalls in stress tests are being lowballed because supervisors do not want to publicize bank problems for which there are no immediate solutions lest they stoke market turbulence.

A Weak Supporting Crisis Management Cast

Over the 2007–16 period euro area economic officials (taken as a group) were less successful relative to their US counterparts in putting together a set of economic policies that make thin the catastrophic tail of the distribution for expected banking sector outcomes.⁷

Table 1.1 shows the Blinder and Zandi (2015) tabulation of the measures the US federal government undertook in response to the 2007–09 financial crisis, Blinder and Zandi (2015, 7) accurately characterize that response as “massive and multifaceted.”⁸ In the euro area, the supporting cast for stress tests has been less impressive. Critics contend that monetary policy stimulus has not been consistent enough or large enough; that fiscal policy consolidation, especially in the crisis-hit euro area periphery, has been too rapid and too large; that the European Central Bank (ECB) was not as aggressive as the Federal Reserve in intervening directly in financial markets to reduce volatility and to stabilize prices; that debt restructuring for the most debt-laden euro areas economies has been too small; and that creditor economies in the euro area, particularly Germany, led economic policy badly astray.

Table 1.1 Cost of US federal government response to the financial crisis (billions of dollars)

GSE = government-sponsored enterprise

a. Net portfolio holdings.

b. Assumes fair value accounting.

c. Includes foreign-denominated debt.

d. Excludes alternative minimum tax patch.

Source: Blinder and Zandi (2015). Reprinted with permission.

German leaders and senior officials misdiagnosed the euro area’s balance of payments crisis as a generalized debt crisis (Wolf 2014b), failed to recognize the pivotal role of a shortage of aggregate demand in the euro area’s dismal growth and employment performance (Wolf 2014b), and (before November 2012) allowed the debt crisis in the euro area periphery to deteriorate into a “bad expectations–led equilibrium” (De Grauwe 2011, 2015). German leadership assumed incorrectly that austerity would by itself generate structural reform, and it underestimated the impact austerity fatigue would have on catalyzing support for populist parties (on both the left and the right) and for populist economic policies. Appendix 1B provides a summary of studies that support the argument that “other” (non-stress-test) crisis management policies were less forceful and less effective in the euro area than in the United States during and after the crisis.

Whatever the explanation, three facts are unassailable. First, the euro area’s recovery from the 2007–09 crisis has been anemic. Truman (2016) gauges the strength of recovery from the global financial crisis by the number of years it takes a country or region to return to the peak precrisis level of real GDP measured in local currency. It took the euro area as a whole seven years (until 2015) to return to the precrisis peak level of real GDP (assuming optimistically that Italy and Greece return to their precrisis peaks by 2021) (table 1.2). The corresponding figure for the United States was four years. For the six euro area crisis countries, the average recovery time was 11 years; the fastest recovery there (in Ireland) took seven years.⁹ (By comparison, after the 1980s debt crisis, when there was also a synchronous global recession, it took the 11 hardest-hit South American countries plus Mexico just over five years to return to peak precrisis levels of real GDP.) In July 2016 the unemployment rate in the euro area (10.1 percent) was more than twice as high as in the United States (4.9 percent).

Second, the euro area has yet to overcome its deflation problem. Annual headline inflation in the euro area was 0.2 percent as of August 2016.¹⁰ It has been below 1 percent for three years—well beneath the ECB’s inflation target of “below, but close to 2 percent.” (See chapter 9 for an update on the euro area’s inflation performance.)

Third, the 2010–16 period has been marked by high volatility in both euro area sovereign risk and EU bank funding risk. It included several episodes where even more serious crises were prevented only at the last minute by the ECB and euro area crisis management initiatives, including, but not limited to, the Outright Monetary Transactions (OMT) and the Long-Term Refinancing Operation 1 (LTRO1), the creation of the European Financial Stability Fund (EFSF) and European Stability Mechanism (ESM), the ESM banking sector loan to Spain, and the troika support programs for Greece, Portugal, and Cyprus.

Bank stress tests do not operate in a vacuum. Where recovery from a historic crisis is weak, uneven, and uncertain and key policymakers disagree about what measures will stave off continuing underperformance for the regional economy as a whole, it is more difficult to make a sale from stress tests that the banks are out of danger.

Higher Outside Estimates of Capital Shortfalls

Outside estimates of the capital shortfall in the EU banking system have been consistently larger than the shortfalls emerging from the stress tests. Ever since International Monetary Fund (IMF) Managing Director Christine Lagarde put a spotlight on the need for “urgent capitalization” of Europe’s banks in her August 2011 Jackson Hole speech, there has been a flurry of estimates suggesting that EU banks are significantly undercapitalized.

Table 1.2 Actual and projected recovery to previous real GDP peak in the euro area

(e) = estimate

Latvia had an IMF program before joining the euro area.

Source: Truman (2016).

Acharya and Steffen (2014c, 1), for example, concluded that euro area banks have been severely undercapitalized since the 2007–09 financial crisis. Using book values of equity and assets, they estimated an aggregate EU capital shortfall of €82 billion to €176 billion. If the market values of equity and assets are employed instead, the estimated capital shortfall rises to €230 billion to €620 billion. Acharya and Steffen estimated the capital shortfall during a hypothetical systemic financial crisis (with a 40 percent decline in a market equity index) at €580 billion. Acharya, Schoenmaker, and Steffen (2011) reached similar results.

The IMF (2011b) and OECD (2013) estimated the aggregate capital shortfall for euro area banks at €200 billion to €300 billion and €400 billion, respectively. These estimates are much larger than those in the adverse scenarios of the EU stress tests.¹¹ They also far exceed the €55 billion Single Resolution Fund agreed to by EU finance ministers in December 2013—even assuming that the European Union follows through with its resolution plan to bail in equity holders and junior bondholders in a bank failure before drawing on public funds.

IMF research by Aiyar et al. (2015) indicated that capital ratios in many EU periphery economies are probably significantly overstated, because loan-loss provisions and credit write-downs are much lower than in US banks. Nonperforming loans (NPLs) in the European Union amounted to roughly €1 trillion at end-2014, more than double the level in 2009. Aiyar et al. (2015, 5) summarize the impaired asset problem in the European Union as follows:

Write-off rates for European banks remain much lower than those of US banks, despite a much higher stock of NPLs. Results from a new survey of European country authorities and banks indicate that there are serious and interrelated impediments to NPL resolution in the areas of supervision, legal systems, and distressed debt markets, often compounded by informational and other institutional deficiencies. Insufficiently robust supervision can allow banks to avoid dealing with large NPL stockpiles and carry them on balance sheets for much longer than warranted. Weak debt enforcement and ineffective insolvency frameworks tend to lower the recovery value of problem loans. And markets for distressed debt in Europe—with some notable exceptions—are still underdeveloped, preventing the entry of much-needed capital and expertise.

Poor Design of the EU-Wide Stress Tests

The design of the EU stress tests contributed to their poor reception.

Early (2009–11) Tests

The methodology and results of the initial October 2009 test were described in a three-page press release summarizing the presentation made by the Committee of European Banking Supervisors (CEBS) to Economic and Financial Affairs Council (ECOFIN) ministers and governors. No individual bank results were published (making it impossible to distinguish weak from strong banks); the capital benchmark used in the 2009 test was the tier 1 ratio rather than the more demanding tier 1 common or core tier 1 ratio; and since...