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i want to welcome wharton finance
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professor richard herring to knowledge
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of wharton today to discuss
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the recently completed european bank
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stress tests and that was done by the
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european central bank on the eurozone's
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130 largest banks
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dick maybe you could tell us a little
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bit about
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the background behind these tests and
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what they might mean
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it's an interesting lineage and to see
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the inspiration for it all you really
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need to turn back to 2009 in the united
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states
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most people now
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mark that as the turning point in our
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crisis where we regained confidence in
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banks
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and it was a similar exercise
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the bank regulators devised a stress
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test with three scenarios
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and insisted that banks show that they
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could remain adequately capitalized even
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under the worst scenario
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the interesting thing about our
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experiment is that
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they they forced 19 banks to undergo the
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experiment and 10 of them failed
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ordinarily you'd think that was not a
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good outcome
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but it was accompanied with a scap
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program so immediately they were forced
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to uh take funds from scap to
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recapitalize which they repaid over time
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it's gap being just gap being the
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supervised capital adequacy program and
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tarping the troubled asset relief
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program
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which was this amount of money the
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europeans tried it seeing that it really
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did work in the united states and it's i
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think it worked only because we had that
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very deep government pocket backing it
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up
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and the problem with europe at the first
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time they tried it of course is that
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they were they're really a group of
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independent states that sort of each
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have national champion banks
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and most of the supervisors do not want
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to say anything harsh about their banks
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so
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they did a
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a stress test but it wasn't really very
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stressful and a few days after it
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completed ireland went under
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the irish banks went under the state of
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ireland tried to bail them out it went
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under and set off the debt crisis so
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that's called egg on your face i think
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absolutely
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and the second time they tried it it
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wasn't a lot more convincing because uh
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there again you had a major player that
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that succumbed within a month or so
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um this time the stakes were much higher
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because
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the eu has decided to have a single
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banking authority they really are trying
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to integrate regulation and supervision
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of the entire banking system in the euro
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area
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and the european central bank is going
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to take it on as a subsidiary
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this has been you know years in the
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negotiation
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but the debate which was mainly the
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germans against everybody else was what
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do we do with the losses that are
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already in the system
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and they said looking ahead
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we can anticipate that we would have
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some sort of mutual
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obligation to support the system going
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forward but we do not want to be on the
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hook for legacy losses
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that was what this was designed to do so
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this is uh
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uh more of a of a true exam than a
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little minor quiz which is seems to be
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what they had in the past it's
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they're you know we still don't know for
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sure because only time will tell but
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there there's every reason to believe it
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was much more serious
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um they were very much aware first of
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all the odds are higher because
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um after this the european central bank
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owns the problem so if you accept a
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dodgy bank from one of the nation states
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there are costs to everybody in the rest
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of europe secondly they were aware of
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the tendency of supervisors to perhaps
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be a little bit gentle with their own
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supervisees and so they designed
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examination teams that included
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a national supervisor but also included
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a supervisor from another country
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and a supervisor that was hired by this
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european central bank so you had
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essentially three different perspectives
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and a much greater chance that you were
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going to actually get it right
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does this mean then
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you say only time will tell but let's
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let me ask this why don't we go back to
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the issue of how stressful it was
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because that's an interesting parallel
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with the united states um one of the
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surprising things about the united
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states was when they finally got around
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to announcing the results of the stress
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test we were already in a more stressful
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macro situation than the stress scenario
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so that too makes it a bit puzzling that
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it worked
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in the european case people have have
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been concerned that it didn't
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consider what many people worry about in
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looking ahead at europe such as a
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deflationary impact
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so there are always issues about that
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but there are also technical issues
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about the way in which stress was
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measured
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they looked to a definition of capital
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to risk-rated assets
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that covered up
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at least two
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pretty serious problems
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one they used a definition of capital
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that included two categories of
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accounting terms that are no longer
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accepted internationally one is they
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permitted banks to count deferred tax
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assets that's fine if you're going to
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make profits in the future but if you're
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a bank that is headed for resolution
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that's not going to be worth anything
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and they also
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permitted banks to
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count good will
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and you can ramp up goodwill however you
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like by simply overpaying the
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accountants
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make the charitable
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assumption that you knew what you were
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doing it's the ultimate asterisk isn't
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it absolutely yeah and then the
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denominator is fudge too because they
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maintain the polite fiction that all
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government debt is riskless that it will
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be repaid in full
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and one of the fundamental problems in
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europe is that european banks tend to
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hold
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large amounts of sovereign debt and
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although it's diminished a lot since the
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crisis began there were large amounts of
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cross-border debt
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if you assume the euro is going to work
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and that everybody will be repaid there
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is a real tendency to put the higher
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interest rate stuff that was in riskier
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countries on your books one of the
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things you mentioned
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i thought was interesting and that you
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said they they weren't taking into
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account
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possible deflation in europe which is
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has been a threat since the crisis but
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recently has been seen as an even
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greater threat as uh
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inflation seems to be dropping
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even more i believe um so
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is this a case of generals fighting the
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last war looking at well we know that we
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think that these stress tests would have
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prevented
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catastrophic failures if it was the same
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kind of crisis we had in 2008 but of
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course the next crisis is likely to be
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different
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i think i'd put it a little differently
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i think they were trying to remove
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one part of what they viewed as
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deflationary pressures
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and the concern had been that european
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banks were so weakly capitalized that
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they really couldn't
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provide loans that would help fuel
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recovery in europe
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now it's well to remember that in europe
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this is a much more serious problem than
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it would be in the united states not
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that our banks aren't important
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but they account for about 20 to 30
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percent of of lending and in europe it's
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more like 70 plus
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so having a banking sector that is not
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able to um supply credit to the the
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private sector means that you're really
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not going to have robust growth so part
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of the idea behind these tests
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was to prove to everyone and to remove
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from sort of the public debate
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it's a problem that our banks are too
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weak it's now pretty clearly if you
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believe the test results a problem that
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demand is much too weak and they're
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going to have to focus on that
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that's really interesting because that's
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uh
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um
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that's a big change then you know so so
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it's not a lack of confidence in the
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bank that's keeping the european economy
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so far below its potential for the last
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five or six years we hope that's true
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there were some indications uh in terms
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of the rates that banks paid right after
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the test that there was at least some
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positive movement in confidence in
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european banks
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and you know it's the same problem we
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faced in the united states
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why is it we don't see more bank lending
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is it because banks are trying to
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deliver and can't really don't want to
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make loans
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if you ask banks they say they've never
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been more liquid they're always looking
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for opportunities um or is it because
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there's not enough demand that's what
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banks say but when you talk to
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entrepreneurs and people are looking for
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mortgages they say this is really tough
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to get so
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it's hard to measure um
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that's interesting you would think that
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there'd be some way to know what was
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really going on there but uh so so the
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evidence is just conflicting is that it
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yeah it's uh we haven't really been very
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good at sorting out um the effects of
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sort of rationing of credit well we know
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that rationing takes place but whether
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um we're not seeing more robust demand
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because the demand isn't there from
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entrepreneurs and investors
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possibly because they don't see much in
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the way of attractive opportunities and
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they themselves are worried about being
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over leveraged
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or because banks
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just don't feel strong enough to lend
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they may have
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as in the case of europe probably two
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years ago weak assets they haven't
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revealed yet and so they want to try to
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build up
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earnings to be able to
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somehow absorb the losses before they
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have to make them public and it's
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you know it's complicated
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so
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it's been a week now uh and um
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i mean i guess
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one could say that the markets seem to
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have accepted uh the verdict of the ecb
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in these stress tests as you say at
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least for now and time will tell yeah
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all the rest of it but they didn't react
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in a way that said oh these these tests
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were just a fiction no they didn't and
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that in itself was a triumph because
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this was a real
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really difficult
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test for the the new european banking
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authority this was essentially
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how you were going to qualify banks to
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enter the new system
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and if it had been a complete softball
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sort of test
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and they'd passed everybody as some
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europeans thought they would because
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they argued they'd all been raising
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capital for a while i think it would
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have had no credibility we've sort of
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seen that that movie before and we know
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it ends badly on the other hand
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they were in a position where if they
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actually were to fail one of the very
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large banks
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it isn't clear they had the mechanism in
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place to resolve it
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because
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there really isn't that much funding at
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the european level and depending on
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which state it is they may or may not
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have enough funding to do it so that's
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interesting so this was the ultimate
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curved test in a way they wanted to have
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some failures i think they looked the
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largest was the oldest bank in the world
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monta
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de pescado siena and uh i think their
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stock dropped 20 percent i think so
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twenty percent uh that okay um from a
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not very high level i would add because
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it's an already just slightly distressed
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level um
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one of the numbers that was really
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buried
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uh in the report but which
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a couple of analysts did pluck out and
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and i i noticed also
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was this uh
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something called the comprehensive
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assessment of the stock of bad loans
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they actually call it non-performing
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exposures we can we call it
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non-performing loans in the us basically
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it's bad loans loans that have a
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a high chance of never being paid back
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and you know in that number there's all
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kinds that are more or less likely to be
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paid back i guess
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that number was really big and
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in dollar terms it was uh
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over a trillion dollars and in fact as
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they went through the stress tests they
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uncovered something like 138 billion
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more in these non-performing or bad
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loans than than
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the authorities did that is than they
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thought was was going to be there
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and um and it's a big number it is
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actually
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uh nine percent of the eurozone's gdp so
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it's it's pretty big
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on the other hand um
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the authorities said that the bank's
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capital shortfall was only about 25
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billion so i just wanted to
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find some way of reconciling that big
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gap so you've got all these potentially
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bad loans but they're telling the banks
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oh you've only got to increase your your
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uh you know your your share of money
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that you're holding on to to account for
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that by 25 billion well it it's a little
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more complicated than that because the
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normal process and and
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by the way it's typical of any bank
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examination process that examiners will
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find assets on the book that they think
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are not properly valued and they will
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almost never say something is
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undervalued so almost always one of the
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results is look you've got this many
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more assets that we think are dubious
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and in order to
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get to a safe and sound position we want
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you to accumulate
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more reserves and that means provisions
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out of current income
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so that if these assets should go bad it
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won't affect your income or capital
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so you're sort of anticipating the worst
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now these are
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forward-looking and that's one of the
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fascinating features of the stress tests
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it's a real sea change in the whole
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attitude toward bank supervision
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before the crisis virtually all bank
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supervision was sort of looking at what
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we see in today's figures which is kind
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of like looking at the future with the
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rear view mirror
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these really try consciously to look
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ahead uh by forecasting what your
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position will be
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under a variety of positions so
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the notion behind these assets would be
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that these assets might well
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not be paid in full
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the number is less than people thought
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it would be so in that sense uh it was a
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pleasant surprise people thought it
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would be even worse
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um but in fact
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depending on the definition they've used
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and i haven't haven't looked at the
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document carefully enough to know but
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typically you'll start classifying loans
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or assets
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according to how much past due they are
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and
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typically in the u.s you'll use a 90-day
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period
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and
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if they remain
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not paid for longer than that then you
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are supposed to allocate more and more
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to it so that
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unless it happens just abruptly
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by the time you finally have to declare
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a loss you will have reserved enough to
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to be able to absorb it
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okay
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those were all my questions is there
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anything else we should be covering on
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this that would be
00:15:02
particularly important for viewers well
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it all sounds like a within the eu kind
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of issue that is more than a little
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technical but we actually do have a lot
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riding on it
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if the european banking system doesn't
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regain health not only is it a problem
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for our financial system but it's a huge
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problem for the european economy and
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they haven't been a significant source
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of aggregate demand in the world
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we could hope that they would finally
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get there not only for their sake but
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for everybody else's as well
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you
