Stress tests, AQRs and banana skins

AQR = Asset Quality Review.

It is the detailed analysis that The European Central Bank (ECB) has to do over the next 12 months concering the main Europen Banks ( including the three largest Maltese Banks) before it takes over direct responsibility for their supervison as part of the EU's plan for a banking union and a common deposit insurance scheme.  These are necessary to restore confidence and stability to the EU's banking system.  

The banking union and common deposit insurance scheme are indispensable pre-conditions for restoring economic growth which depends on a properly function credit system and a reliable transmission mechanism for the ECB's monetary policy.

The AQR can only be credible if the ECB sets tough standards which challenge the inflated asset values that still sit on European banks' balances sheets, not least German regional banks,  that have not been properly marked down to their real value.    Yet if the ECB is too tough it could uncover a capital deficiency gap so wide that causes the inverse effect of creating a confidence crisis.   This makes it compelling to have some ready mechanism to fill up the gap with new capital that restores bank equity resources to confidence building levels.

Unless the exercise is properly planned and perfectly executed it could either be ineffective if the markets judge that the stress tests used for the AQR as too soft (as has been the case with the two previous stress tests executed in 2010 and 2011) or worse it could trigger a crisis of confidence fire without have the back-stop fire engines at the ready.

The major two factors which will determine the capital deficiency is the valuation to be given to the banks' holding of sovereign debt portfolios and perhaps even more critical the haircuts to be applied to loans to private sector borrowers that are not servicing their commitments.

For sovereign debt holdings there is a ready market price and any stress tests that avoids marking such asset to their market price, given that there is now relative stability on capital markets, would probably be considered as not rigorous enough.

There is however no ready market price markers for the true value of the loan books, especially that part which is considered non-performing i.e. where interest and capital repayments are not being met.
There is much dead stuff to be uncovered in the valuation of such private sector loans sitting on bank balance sheets in Europe.   The EU average of 5% of non-performing loans as a percentage of total loans seems unquestionably weak.   Germany's rate of just 2% is highly suspicious especially knowing the problems with balance sheets of regional banks that are in repair mode denying access for credit to SME's who had to seek the bond capital markets to service their financing needs.

Malta has a very resilient banking system.   We have proven this during the crisis and the way we shrugged off contagion risks as the Cyprus banking system nearly collapsed and unfair international comparisons started being made between Malta's and Cyprus' banking systems.   Yet Maltese core banks had a non-performing loan ratio of 8.1% (2012) of total loans which has consistently crept up from a pre-crisis level of around 5%.

Using Malta's benchmarks may indicate the size of the haircuts which other European banks still have to do if the AQR discipline of the ECB is to have any teeth.

Which brings us to the question of how the capital deficiency resulting from a properly dosed AQR is to be financed.

Two school of thoughts still prevail.   The German school wants to use the Cyprus model where the capital deficiency is filled as much as possible by bailing-in bondholders and uninsured depositors in order to make the least possible reliance on recapitalisation by the sovereigns directly or through ESM ( European Stability Mechanism).     The ECB view is that recourse to the Cyprus bail-in model could destablise the markets and force bondholders to dump their investments reducing asset prices further and forcing banks into a loop which increases the capital deficiency.

It is crucial for this issue to be settled with prudence and wisdom.   Both sides have strong arguments to support their positions and there is no ideal solution to choose from.   I should think that the best of both system needs to be taken.    To the extent that there results negative equity in individual banks it would be unavoidable to use the German model to bail-in creditors in the order of their priority ranking to neutralise the negative equity after wiping out the existing shareholders.   However once the negative equity has been addressed, additional capital to the confidence level required should be contributed by the ESM.    Sovereigns already have too much on their plate and they should not be burdened with more bank recapitalisation commitments which would drain away fiscal funds needed to restore sovereign balance sheets back to health.

Obviously the question is:  does the EMS have enough resources to meet the recapitalisation requirements which could be very big, if the AQR is to gain market approval??

For me this is a moot point.   The ESM should have whatever resources are needed to address the additional capitalisation requirements.  And I argue that these have to be big enough to shock and awe the markets so that there is no question that at the end of this exercise the main European banks will be healthy and capable of acting as credit creators to service economic growth and give full effect to the ECB's monetary policy.

If the existent ESM resources prove insufficient the ECB should have no qualms to monetise in favour of the ESM whatever they need to fund such recapitalisation.

For those who think that such monetisation is dangerous or disingenious they should just realise that extraordinary situations require extraordinary measures.   They should read a brilliant Occassional Paper just published by the Group of Thirty based on Lord Adair Turner's speech to the Cass Business School in London last February 6th, 2013 titled:

 "Debt, Money, and Mephistopheles: How Do We Get Out of This Mess?"

A brilliant paper which should make Lord Adair Turner a clear favourite for a future Nobel Prize for Economics award.