European financial officials are considering a new round of stress tests with more stringent criteria to address declining investor confidence in the Euro, European banks and European country solvency.
To be successful at addressing this decline, the stress tests will have to overcome two significant hurdles.
- Credibility. As the old saying goes, fool me once shame on you, fool me twice shame on me. The Irish bank experience shows the first round of European stress tests did not provide an accurate picture of what was actually going on within the Irish banking system. Why should investors believe a second round of stress tests will produce an accurate picture of what is going on inside the other European banks?
- Verifiability. As Ronald Reagan use to say, "Trust, but verify." Even if the criteria and the results are disclosed, how are investors going to verify the accuracy of the stress tests?
Fortunately, there is a solution that would make the stress tests both credible and verifiable.
The European governments could require the banks to disclose current loan-level performance and their investment positions (this captures sovereign and foreign bank debt exposures).
This would allow market credit analysts to not only verify the results of the stress test, but to run their own stress tests. This in turn restores trust in the conclusions drawn from the European stress test.
With all market participants knowing which, if any, banks and countries need capital, the situation can be addressed and the decline halted.
Disclosure: No positions