Nobody wants to fail a stress test, right? After running on a treadmill for ten minutes, every patient anticipates the all-clear from the cardiologist with no need for procedures, infusions, or any other remedial steps. But if you are a bank, your stress test isn’t in a doctor’s office, and your bad news can’t be cured by upping the statins. In November, one of Europe’s largest banks failed its stress test, and the doctor’s orders are: infuse $2.5 billion in fresh capital.
Avoiding 2008 Redux
Just two years ago, the European Central Bank (ECB) took over supervision of 120 European banks it deemed to be “significant.” That, of course, was a euphemism for the real concern that instability in the European banking sector might lead to a US-style financial disaster and its concomitant taxpayer bailout. The excuse for the takeover was the need for a “European banking union,” but no one could hide the fact that six years after The Great Recession, regulatory jitters were still being felt overseas. As in the United States, European regulators adopted harsh asset reviews and sophisticated algorithmic “what if” scenarios dubbed “stress tests.” The Bank of England (BOE) came up with its own metrics for averting a UK financial crisis, and last month, it put its biggest royal banking subjects to the test.
Toughest Stress Test Yet
In what has been called the toughest stress test to date, the BOE measured how seven of its biggest banks would fare under a theoretical scenario that included a housing market crash, a recession, and other significant market crises. One bank, which is 73 percent government-owned after being bailed out in 2008, failed its liquidity risk test, falling $2.5 billion short under worst-case scenario modeling. Two of its industry rivals also fared poorly but were not ordered to revise their capital reserve planning.
In addition to ordering the capital infusion, the BOE ordered the bank to divest of approximately $10 billion worth of assets deemed to be too risky. A senior officer with the bank assured the public that the bank remained committed to maintaining strength and safety for both its customers and shareholders, proclaiming, “We have taken further important steps in 2016 to enhance our capital strength, but we recognize that we have more to do to restore the bank’s stress resilience including resolving outstanding legacy issues.”
Not the Real Economy
Some critics of the strict stress test parameters note that the stress test analytics used do not reflect real-life dynamics. That sentiment was alluded to in a statement by the bank’s Financial Policy Committee, which noted that “the banking system is in aggregate capitalized to support the real economy in a severe, broad and synchronized stress scenario.” But in announcing the test results, the BOE ominously warned of a “challenging period of uncertainty around the domestic and global economic outlook.”