Way back in June, I published an article entitled, "Why The Spanish Bank Stress Test Results Were Interpreted Far Too Generously". In that piece, I highlighted a number of things that, to me, seemed rather odd about Oliver Wyman's (OW) "independent" stress test of the Spanish banking sector. Specifically, I noted that
"...it seems...the steering committee is throwing 'stability and confidence' out the window when it recommends that the auditors assume only a 6% core Tier 1 ratio when calculating Spanish banks' capital needs under the so-called 'adverse case.' This leeway is what accounts for the 35 billion in 'excess capital buffers'. If you go by the EBA's stability-promoting...9% core Tier 1 capital ratio, that excess capital buffer all but disappears."
At the time, this was a rather contentious statement. It seems that many would have it that, depending upon the scenario, banks should be allowed to simply take 3 percentage points worth of reserves from the mandated capital buffer and call it "excess capital." Of course, it can't properly be called "excess" if all that was done to get it was to arbitrarily reduce the mandated capital requirement.
Now that the final version of the OW report on Spain's banking sector is in, Moody's is raising the exact same question I raised in June. From Moody's:
While many of the assumptions used in the exercise are conservative, others that materially reduce the aggregate capital shortfall could be questioned. For example, the headline adverse-case cumulative credit loss of €270 billion is largely offset by assumed 'loss absorption capacity'. That loss absorption comes primarily in the form of existing provisions (€110 billion), excess capital buffer (€73 billion), and forecast pre-provision earnings (€61 billion). Notably, the required capital target is relaxed to 6% core Tier 1 in the adverse scenario from 9% core Tier 1 in the base scenario, providing €51 billion of additional capital to offset bank credit losses.
Spain's approach is explained with the statement that capital requirements in any stress test must be different in the base and adverse case, because macroeconomic conditions under the adverse scenario have a very low probability of occurrence. Ours, by contrast, measures capital needs against a consistent benchmark under our base stress and adverse stress scenarios. (emphasis mine)
So Moody's does what any sensible person would do: they use the same capital target for both the base case and the adverse case. This way, the results can be fruitfully compared. The ratings agency estimates Spain's banking sector will need between 70 and 100 billion euros versus the OW estimate of 59.3 billion euros.
Another interesting thing about this whole scenario is that it would appear, based on language in OW's report, that the reduction in the capital requirement is justified by reference to some theoretical deleveraging by Spanish banks during a pinch:
"To improve the quality of the projected loss absorption, we...utilized a structured approach to model the additional capital buffer resulting from deleveraging, by estimating RWA reductions in line with projected entities' credit volumes by asset type in each scenario...Credit deleverage has the effect of reducing an entity's total risk-weighted assets (RWAs) and subsequently, capital requirements. (emphasis mine)
It seems that OW has sought to justify the reduction of the Tier 1 capital requirement from 9% in the base case to 6% in the adverse case by claiming that in the adverse scenario, Spain's banks will sell off more of their risky holdings than they would have in the base case, thus reducing their risk-weighted assets and, by extension, the amount of capital they are required to hold.
If this is indeed what OW is implying, it should be noted that the decision to reduce the capital ratio for the adverse scenario is based entirely on speculation about future asset sales. As ZeroHedge cleverly notes, this may be an extraordinarily bad assumption to make in this scenario given that as deposits leave Spain, Spanish banks are forced to stem the flow by pledging collateral to the ECB for cash. They are likely to need cash most during a so-called "adverse case." Because cash requires collateral in the case of Spain's banks, they cannot sell assets (as posited by OW) because they will need to pledge them to plug holes left by fleeing depositors.
In the end, investors should be wary of putting too much trust in the results of the Spanish bank stress test. This is just another example of the manipulation of data based on a set of dubious assumptions. Indeed, even if the intentions of OW, the IMF, Spain, and the ECB were honest, the circular funding scheme in Europe has become so self-referential that "fixes" are sometimes also problems (as in the above cited case of Spanish banks' asset sales). This provides the skeptical investor with yet more evidence to support a short position in European equities, like the SPDR Euro Stoxx 50 ETF (FEZ) and the euro, CurrencyShares Euro Trust ETF (FXE).
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.