The European Bluff, Take II: Seeing Isn't Believing

by: The Fortune Teller

"Seeing isn't believing, but believing is seeing."

If you listen to the EBA and ECB, you would think that the European banking system is in very good shape.

However, when you look at the market - and especially when you listen to the ECA - you understand how far this is from the truth.

You wouldn't believe what a sad joke the European "stress tests" have become. Sad and alarming alike.

Almost a year ago, we discussed "The European Bluff, Take I" around the ECB decision to stop injecting money to the European markets (VGK, EZU, HEDJ, FEZ, IEUR, BBEU, IEV) at the end of 2018. We wrote (in a handful of articles) that there's no way the ECB will be able to stay on the sidelines for too long. To wit:

The big question now is how quickly the ECB will announce a new purchase plan. It can't reverse course, but it can decide on a new one. However, until it does, the European economy continues - and is probably destined - to gallop towards the cliff.

Just as we predicted, it took the ECB only a few months to realize that the European markets can't function without the assistance of the "big brother." The ECB has already announced new measures, aiming at easing the already-extremely-loosened monetary policy, with a new QE plan seems inevitable.

It's now time to discuss another stunning European bluff - the EU banking system. The same banking system that its regulator, the European Banking Authority ("EBA") has praised following the most recent stress tests at the end of 2018 (Note that unlike the Fed, the EBA conducts its stress tests for European banks only once every two years)

Overall, the EU banking sector has continued to benefit from the positive macroeconomic developments in most European countries, which contributed to the increase in lending, further strengthening of banks' capital ratios and improvements in asset quality. Profitability remains low on average and has not yet reached sustainable levels.

Commenting on the outcome of the exercise, Mario Quagliariello, Director of Economic Analysis and Statistics at the EBA, said:

The outcome of the stress test shows that banks' efforts to build up their capital base in the recent years have contributed to strengthening their resilience and capacity to withstand the severe shocks and material capital impacts of the 2018 exercise. The results will be used by supervisors as part of their wider assessment of banks' vulnerabilities and input to their supervisory decisions.

The results of the stress tests conducted by the EBA received the approval of the ECB, which actually claimed thereafter that "the European banking system is more resilient to financial shocks."

My reaction: Really!? Seriously!? You gotta be kidding me, and that's before I even spell out "Deutsche Bank" (DB)... A quick look at the stock performance of leading European banks* over the past decade reveals a completely different picture.

*List of European banks appearing in the below chart includes the following:

  • Deutsche Bank AG
  • UniCredit SpA (OTCPK:UNCFF)
  • BNP Paribas (OTCQX:BNPQF)
  • Societe Generale SA (OTCPK:SCGLF)
  • Credit Suisse Group AG (CS)
  • The Royal Bank of Scotland Group PLC (RBS)
  • Lloyds Banking Group PLC (LYG)
  • Barclays PLC (BCS)
  • Banco Santander SA (SAN)
  • Commerzbank AG (OTCPK:CRZBF)
  • Banco Bilbao Vizcaya Argentaria SA (BBVA)

European banks over the past decade: Anything but resilient

The above chart speaks volume, but it doesn't stop here. For the first time, we now have an official internal insider voice telling us the truth about European banks, on top of Mr. Market.

The European Court of Auditors ("ECA") conducted a thorough examination of the EU-wide stress tests and in a special report, titled "EU-wide stress tests for banks: unparalleled amount of information on banks provided but greater coordination and focus on risks needed", the ECA is turning these stress tests into a (bad) joke.

Here are the main failures that the ECA is pointing out:

1. Quantity: Number of examined banks.

In the first round of stress tests that took place in 2011, no less than 90 banks from 21 countries were tested. In the last round of stress tests, from 2018, only 48 banks from 15 countries were examined.

2. Quality: Who has been left out.

I trust we all agree that the most problematic banks are the ones posing the biggest threat to a banking system, right? As such, stress tests should include the most problematic banks/countries, correct? Not according to the EBA.

Can you guess banks from which countries were left out of the stress tests? Italy (EWI), Greece (GREK), and Cyprus. How convenient! I'm almost surprised they kept DB in.

3. Soft, certainly not stress, tests.

The most negative scenario that was examined didn't address the most burning systemic threats that the European banking system is facing. The ECA report argues that the negative scenario that was tested in the 2018 stress test is simply neither sufficient nor representing the type of danger that the system is likely to go through.

The negative scenario examined the resilience of the banks against an economic slowdown, rather a shock stemming mainly from failures in the financial/banking system itself (as happened over the past year).

The ECA also indicates a few important parameters that were left out of the recent tests, e.g. the effect of negative interest rates on banks' profitability, the exact state of non-performing loans, and liquidity issues among banks.

The report argues that the scenario presented in the last stress tests is nowhere near the situation that banks encountered back in the economic crisis of 2008.

The question that arises from this crucial failure is simple: How can one decide whether European banks are more resilient to a certain 2008/9 like situation when the situation that the stress tests actually examine is holding a much lower bar!? You can't claim that the banking system can withstand a certain threshold if that threshold isn't being tested!

4. Do it yourself

Last but not least, sit tight, as this is the most alarming of all failures!

Can you guess who is calculating and marking the stress tests? If your answer is the EBA, the ECB, or any other three-letter acronym starting with an "E" - you might wish to take another guess.

Believe it or not, but those are the examined banks themselves that calculate and mark their own tests! Yes, you heard me correctly: European banks are being tested and they are also the ones that give themselves the final grades. How convenient (no, 2)!

The report also notes that the EBA is not doing enough - neither to verify the data nor to ensure the reliability of the results (by the way, the report also criticizes the ECB for not doing its part as well). As it turned out, the EBA has only "about" 7 full-time employees responsible for conducting, analysing, and publishing the stress tests data. No wonder they are happy to get a helping hand when they find themselves in times of trouble/stress... Let it be!

To sum this all up in a simplistic, though accurate, manner:

The EBA created a particularly easy test, removed the weaker "students" from the class before the test begins, and let the students who took the test to mark their own papers and calculate the final results. Then after, the "school" proudly announced that all students who took the test have passed it successfully. Have I already used "How convenient" in this article?

Recall that the troubles in the European banking system have moved back to the center stage recently, as a result of the restructuring process that DB announced, which include laying off no less than 18,000 employees.

The biggest problem continues to be Deutsche Bank's gigantic derivatives portfolio, which is estimated to be worth anywhere between 43 to 45 trillion euro. This is an enormous size that is way bigger than what Lehman Brothers (LEH) held on its books back in 2008.

As of now, it seems like DB has managed to "escape" from the "LEH fate chart."

However, when even the NY Post discusses "How Deutsche Bank Could Turn Into Another Lehman Brothers," you know that the European banking system is anything but resilient.

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.