Looking at each of these factors in turn, the stress tests were not very credible in terms of the scenarios and assumptions. Rather, the tests look to have been designed to ensure that as few banks as possible fail (as it was, 7 out of 91). As a result, the results were not accompanied by a plan for recapitalization or consolidation, beyond what some countries had already announced. And there was no mention of potential cross-border support for banks, if needed, or how that might be achieved.
Only on the information disclosure item can you award very high marks--and even then without universal application. In the case of Spain, the overall credibility of the tests was well above average, not least because Spain has been a chief proponent of the stress tests, owing to market concerns over both the sovereign debt dynamics and the potential hole in the Spanish savings bank system.
Market reaction has been positive, largely it seems because the information disclosure was better than expected largely across the board. This is important. It was the "market for lemons" problem of which bank had exposures to what sovereign that has left banks unwilling or unable to face each other and the European Central Bank (ECB) as the intermediary of last resort.
Yet it is hard to arrive at the conclusion the stress tests will mark a fundamental turning point. Rather than being designed to truly assess the potential capital shortfalls in the banking system, they appear to have been designed to ensure that hardly any banks failed and those that did have very little capital to raise.
Rather than the stress tests being a game changer, one is left with the nagging feeling that this was another opportunity missed. For the European policy response again appears to have been geared to the short term and expedient. There are dark clouds outside already, but it is still a good time to repair some roofs, given the danger that a nasty storm could develop.
The various attempts to address liquidity, including the support for Greece, the nascent European Financial Stability Facility "“ the special purpose vehicle to allow governments to provide support to their neighbors "“ and the ECB provision of funding and its buying of government bonds, may all help to buy time for countries to make their fiscal adjustments. Market reaction in recent weeks in turn reflects this curtailment of immediate liquidity-related tail risks.
But while the focus has been liquidity and buying time, the underlying problems are fundamental, and long term in nature. In contrast to the U.S. and its stress tests last year where the provision of sovereign balance sheet was part of the solution, in the European case stressed debt dynamics in some countries are at the center of the problem, along with the broader concern over growth and deflation risks.
A number of euro zone members, notably those in southern Europe, have to make very difficult fiscal adjustments. They do not have the benefit of independent monetary policy or flexible exchange rates. There is the question of how they will be able to grow into more sustainable debt dynamics at the same time as delivering the fiscal policy cuts. History does not provide a lot of good examples of such transitions. There is uncertainty over the extent to which membership of the European Club can help to cushion the adjustment, certainly with a policy response that has focused on liquidity provision and kicking the can down the road.
These adjustments will not be easy, not least because of the problem of the fallacy of composition with countries across Europe trying to tighten fiscal policy at the same time and the difficulty of achieving and sustaining public support for a long period of austerity.
This material contains the opinions of the author but not necessarily those of PIMCO and such opinions are subject to change without notice. This material has been distributed for informational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Statements concerning financial market trends are based on current market conditions, which will fluctuate. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. This material was reprinted with permission of Forbes. Date of original publication July 28, 2010.
No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. Pacific Investment Management Company LLC, 840 Newport Center Drive, Newport Beach, CA 92660, 800-387-4626. ©2010, PIMCO.
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