Shortcomings of the "adverse" EBA stress test scenario

The results of the stress test conducted by the quite young European Banking Authority are out now. As expected, not more than 10 banks failed the test and, in a nutshell, the results are quite relaxed putting little further pressure on European financial institutions.

Overview:

* At the end of 2010, twenty banks would fall below the 5% Core Tier 1 Ratio
(CT1R) threshold over the two-year horizon of the exercise. The overall
shortfall would total EUR 26.8 bn.
* Between January and April 2011, a further net amount of some EUR 50 bn of
capital was raised.
* Taking into account these capital raising actions implemented by end April
2011:
– Eight banks fall below the capital threshold of 5% CT1R over the two-
year time horizon, with an overall CT1 shortfall of EUR2.5 bn.
– Sixteen banks display a CT1R of between 5% and 6%.

The tests were construed to examine “the resilience of a large sample of banks in the EU 1 against an adverse but plausible scenario” (EBA).

But what does this tell us? The informative value of the stress test relies on the choice of the scenario. And there a some goods reasons to doubt its quality.

For instance, The Economist points on two shortcomings of the construction of the scenario:

  1. The test ignores the severeness of the euro crisis: It only takes a moderate haircut of sovereign debt into account, 15 percent for Greece, for example. What will happen if there is a real default in the European perphery, the test cannot tell us.
  2. The test ignores the typical structure of such crises: It only regards the direct effects of, for instance, a Greek default. it does not take possible contagion effects into account.

That is, the scenario might be not “adverse” enough to forecast the potential problems that the EU banking sector will face within the next year.

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