The Major Flaw In The European Bank Stress Tests - And What To Do About It

| About: CurrencyShares Euro (FXE)


European bank stress test results published this week showed the banks to be in better shape than many expected.

Not assuming any sovereign defaults, however, may have made the tests too optimistic.

The answer is not to fix the tests, but to fix one of the major flaws in the design of the euro.

The flaw is that European banks have no safe asset in which to invest their liquidity.

That can be fixed by allowing the ECB to issue bonds that can be owned only by banks.

Europe is at a crossroads. Of course, Europe so often is at a crossroads, and so often the crossroads seem to go on and on. Crisis, therefore, is frequent and, contrarily, ongoing.

The biggest apparent current European crisis is the immigrant crisis, which is real and continuing. I also would not make light of the centripetal forces tearing the EU apart. And I would not make light of the divisiveness caused by the flaws in the structure of the euro. But there are forces and bonds that could keep Europe together. The question is whether those forces can overcome the forces of division before chaos sets in.

The future of Europe now may depend on how Europeans (and particularly Germany and its northern allies) react to the recent ECB (the European Central Bank, which was assisted by other agencies) bank stress tests - and the glaring defect in the stress test process by means of which the results were achieved. The glaring defect is that no sovereign defaults were assumed. But that is a defect in the design of the euro, not in the design of the tests. And it is a critical flaw in the design of the euro that can be fixed fairly easily, if there is political will to do so. That having been said, let's take a look at the results, as presented by Bloomberg:

These results are more encouraging than the majority of forecasts had suggested. Only Ponte dei Paschi of Italy comes out insolvent. That bank has long been known to be a problem, and there are several steps being taken to recapitalize it. There are other banks that have significant shortfalls of capital when the severe stress test is applied, but it appears that they could, with diligence, improve their capital bases.

Yesterday, "And Value for All" published a good summary of the stress test results on SA. I recommend it to those who want some good analysis of the details.

A Fundamental Flaw in the Euro

My focus in this article is on the basic flaw in the stress test methodology and what can be done about it. A Bloomberg editorial headed "Europe's Stress Tests Fail Again" focused on this flaw and suggested that it was a serious problem. Simply stated, the stress tests did not include any assumption that a sovereign in the euro area could default on its obligations, although Greece has defaulted (by any reasonable interpretation), Portugal and Ireland have been sort of bailed out, and Spain and Italy survive with the assistance of the ECB. (The FT also has weighed in, expressing doubts about the benefits of the stress tests.)

The Bloomberg criticism is fair in the sense that there could be a sovereign default, and if there is such a default, that will be very serious for just about all of the banks that call the defaulting nation home. But the criticism is not fair if one considers that if the U.S. defaulted on its obligations, most U.S. banks would go under as well. That is because a bank needs to have some form of safe asset that it can own in quantity without incurring credit risk or currency risk. U.S. securities are that for American banks, U.K. obligations for British banks, and Japanese obligations for Japanese banks. The banks of the euro area have no such safe-haven asset, because no individual country issuer has the right to print euros to pay off its debts.

Seen in that light, the European stress tests are right not to include sovereign defaults, even though such a thing could happen. And that points to the requirement that there be a riskless asset that European banks could own.

I need now to return to my lead paragraphs about the future of Europe. The euro cannot readily be reversed without incurring chaos and threatening the existence of the EU itself. The euro is seriously flawed, and therefore, it needs to be fixed. A big step in fixing the way the euro works would be to decouple the banks from their home country finances. This has been recognized explicitly by the ECB and by the European Commission, and it is the goal of the various banking directives of the last few years. But Europe and its banks cannot get to the banking convergence they need without a safe asset that can be held by all banks in the euro area.

Debt issued by the ECB

Such an asset is not difficult to imagine. It could be debt issued by the ECB, which banks could get in exchange for the sovereign bonds they now hold (equal tenor and only bonds purchased before a certain date), and which banks could buy directly from the ECB. Such bonds would be eligible for sale only to banks within the euro area, but they would get added liquidity by being officially accepted as collateral at the ECB without a haircut. (One could think of such bonds as being like reserves with various tenors.)

Such a debt security would cure the most fundamental ailment of many of the banks of Europe, and would clear the way for European deposit insurance and greater consolidation of the banks of the Continent. It would not cure the business plan problems that many of the large banks are experiencing, but that is something each one has to work out for itself.

Without greater banking integration and banking strength, it hard to see how the euro area can cure its design flaws. Fixing the banking problem is not a panacea. Major issues would remain, but fiscal and political issues would come to the fore if the banking issues were fixed, and the fiscal and political issues might be addressed more productively if the prominent banking issues could be successfully resolved.


John M. Mason published an excellent article on SA a couple of days ago, in which he discussed Joseph Stiglitz's forthcoming book, The Euro: How a Common Currency Threatens the Future of Europe. It is pretty late in the day for Stiglitz to be telling the public that the euro threatens the future of Europe. I suspect that even schoolchildren in China (though maybe not in the U.S.) are aware of the problem. But even more shocking, at least going by reports so far, Stiglitz does not offer a road map for the transition from the difficult place where we are to his vision of a new (old?) system of separate nations with separate currencies living in harmony and paying high wages to unionized populations. That vision is even less workable than the single currency. (Stiglitz studied economics at Amherst. I studied history.)

Stiglitz is not alone in his myopia. Many commentators deride the euro and point to the various I-told-you-so's back in the 1990s. The naysayers were right about the serious flaws. But the world that existed 20 years ago will not come back. Policy has to deal with the world that exists today and figure out the best way forward - which is not likely to be backward.

The history of Europe from 1066 to 1945 is a history of war and pestilence, punctuated occasionally by great artistic and intellectual achievements. From 1945 to date, the history of Europe is peaceful. Henri IV, king of France in the 17th century, who had been raised a Protestant, said it was worth converting to Catholicism to become accepted as king. "Paris vaut bien une messe," he is famous for saying. Just so, it will be worth it for the Germans to assent to a true common currency, including the ECB issuing bonds that are the common responsibility of all the nations of Europe, in order to secure another 70 years of peace.

Can that happen politically at a time when the centripetal forces are in the ascendancy? Of course, I do not know. But when voters look chaos in the face, they may choose cooperation instead. (How does Brexit look to the average German?)

Coming back from close to the brink will be a slow process with many steps. But a good next step would be for the ECB to issue bonds that banks could use as their primary liquid assets.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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