00:00:02
i want to welcome wharton finance professor richard herring to knowledge of wharton today to discuss
00:00:07
the recently completed european bank stress tests and that was done by the european central bank on the eurozone's
00:00:15
130 largest banks dick maybe you could tell us a little bit about the background behind these tests and
00:00:25
what they might mean it's an interesting lineage and to see the inspiration for it all you really
00:00:30
need to turn back to 2009 in the united states most people now mark that as the turning point in our
00:00:38
crisis where we regained confidence in banks and it was a similar exercise the bank regulators devised a stress
00:00:48
test with three scenarios and insisted that banks show that they could remain adequately capitalized even
00:00:56
under the worst scenario the interesting thing about our experiment is that they they forced 19 banks to undergo the
00:01:04
experiment and 10 of them failed ordinarily you'd think that was not a good outcome
00:01:10
but it was accompanied with a scap program so immediately they were forced to uh take funds from scap to
00:01:16
recapitalize which they repaid over time it's gap being just gap being the supervised capital adequacy program and
00:01:23
tarping the troubled asset relief program which was this amount of money the europeans tried it seeing that it really
00:01:30
did work in the united states and it's i think it worked only because we had that
00:01:35
very deep government pocket backing it up and the problem with europe at the first
00:01:41
time they tried it of course is that they were they're really a group of independent states that sort of each
00:01:47
have national champion banks and most of the supervisors do not want to say anything harsh about their banks
00:01:54
so they did a a stress test but it wasn't really very stressful and a few days after it
00:02:01
completed ireland went under the irish banks went under the state of ireland tried to bail them out it went
00:02:08
under and set off the debt crisis so that's called egg on your face i think absolutely
00:02:13
and the second time they tried it it wasn't a lot more convincing because uh
00:02:17
there again you had a major player that that succumbed within a month or so um this time the stakes were much higher
00:02:25
because the eu has decided to have a single banking authority they really are trying
00:02:31
to integrate regulation and supervision of the entire banking system in the euro
00:02:36
area and the european central bank is going to take it on as a subsidiary this has been you know years in the
00:02:44
negotiation but the debate which was mainly the germans against everybody else was what
00:02:51
do we do with the losses that are already in the system and they said looking ahead
00:02:56
we can anticipate that we would have some sort of mutual obligation to support the system going
00:03:03
forward but we do not want to be on the hook for legacy losses that was what this was designed to do so
00:03:09
this is uh uh more of a of a true exam than a little minor quiz which is seems to be
00:03:16
what they had in the past it's they're you know we still don't know for
00:03:21
sure because only time will tell but there there's every reason to believe it
00:03:24
was much more serious um they were very much aware first of all the odds are higher because
00:03:30
um after this the european central bank owns the problem so if you accept a dodgy bank from one of the nation states
00:03:38
there are costs to everybody in the rest of europe secondly they were aware of the tendency of supervisors to perhaps
00:03:45
be a little bit gentle with their own supervisees and so they designed examination teams that included
00:03:53
a national supervisor but also included a supervisor from another country and a supervisor that was hired by this
00:04:01
european central bank so you had essentially three different perspectives and a much greater chance that you were
00:04:08
going to actually get it right does this mean then you say only time will tell but let's
00:04:14
let me ask this why don't we go back to the issue of how stressful it was because that's an interesting parallel
00:04:19
with the united states um one of the surprising things about the united states was when they finally got around
00:04:25
to announcing the results of the stress test we were already in a more stressful
00:04:30
macro situation than the stress scenario so that too makes it a bit puzzling that
00:04:35
it worked in the european case people have have been concerned that it didn't
00:04:41
consider what many people worry about in looking ahead at europe such as a deflationary impact
00:04:48
so there are always issues about that but there are also technical issues about the way in which stress was
00:04:54
measured they looked to a definition of capital to risk-rated assets that covered up
00:05:02
at least two pretty serious problems one they used a definition of capital that included two categories of
00:05:12
accounting terms that are no longer accepted internationally one is they permitted banks to count deferred tax
00:05:19
assets that's fine if you're going to make profits in the future but if you're
00:05:23
a bank that is headed for resolution that's not going to be worth anything and they also
00:05:30
permitted banks to count good will and you can ramp up goodwill however you like by simply overpaying the
00:05:37
accountants make the charitable assumption that you knew what you were doing it's the ultimate asterisk isn't
00:05:44
it absolutely yeah and then the denominator is fudge too because they maintain the polite fiction that all
00:05:50
government debt is riskless that it will be repaid in full and one of the fundamental problems in
00:05:56
europe is that european banks tend to hold large amounts of sovereign debt and although it's diminished a lot since the
00:06:04
crisis began there were large amounts of cross-border debt if you assume the euro is going to work
00:06:10
and that everybody will be repaid there is a real tendency to put the higher interest rate stuff that was in riskier
00:06:17
countries on your books one of the things you mentioned i thought was interesting and that you
00:06:25
said they they weren't taking into account possible deflation in europe which is
00:06:32
has been a threat since the crisis but recently has been seen as an even greater threat as uh
00:06:38
inflation seems to be dropping even more i believe um so is this a case of generals fighting the
00:06:46
last war looking at well we know that we think that these stress tests would have
00:06:50
prevented catastrophic failures if it was the same kind of crisis we had in 2008 but of
00:06:56
course the next crisis is likely to be different i think i'd put it a little differently
00:07:00
i think they were trying to remove one part of what they viewed as deflationary pressures
00:07:06
and the concern had been that european banks were so weakly capitalized that they really couldn't
00:07:13
provide loans that would help fuel recovery in europe now it's well to remember that in europe
00:07:19
this is a much more serious problem than it would be in the united states not that our banks aren't important
00:07:25
but they account for about 20 to 30 percent of of lending and in europe it's
00:07:30
more like 70 plus so having a banking sector that is not able to um supply credit to the the
00:07:37
private sector means that you're really not going to have robust growth so part
00:07:42
of the idea behind these tests was to prove to everyone and to remove from sort of the public debate
00:07:50
it's a problem that our banks are too weak it's now pretty clearly if you
00:07:53
believe the test results a problem that demand is much too weak and they're going to have to focus on that
00:07:59
that's really interesting because that's uh um that's a big change then you know so so
00:08:06
it's not a lack of confidence in the bank that's keeping the european economy
00:08:11
so far below its potential for the last five or six years we hope that's true
00:08:14
there were some indications uh in terms of the rates that banks paid right after
00:08:18
the test that there was at least some positive movement in confidence in european banks
00:08:25
and you know it's the same problem we faced in the united states why is it we don't see more bank lending
00:08:32
is it because banks are trying to deliver and can't really don't want to
00:08:36
make loans if you ask banks they say they've never been more liquid they're always looking
00:08:40
for opportunities um or is it because there's not enough demand that's what
00:08:45
banks say but when you talk to entrepreneurs and people are looking for mortgages they say this is really tough
00:08:50
to get so it's hard to measure um that's interesting you would think that
00:08:56
there'd be some way to know what was really going on there but uh so so the evidence is just conflicting is that it
00:09:02
yeah it's uh we haven't really been very good at sorting out um the effects of
00:09:07
sort of rationing of credit well we know that rationing takes place but whether um we're not seeing more robust demand
00:09:14
because the demand isn't there from entrepreneurs and investors possibly because they don't see much in
00:09:21
the way of attractive opportunities and they themselves are worried about being over leveraged
00:09:26
or because banks just don't feel strong enough to lend they may have as in the case of europe probably two
00:09:35
years ago weak assets they haven't revealed yet and so they want to try to build up
00:09:39
earnings to be able to somehow absorb the losses before they have to make them public and it's
00:09:46
you know it's complicated so it's been a week now uh and um i mean i guess
00:09:54
one could say that the markets seem to have accepted uh the verdict of the ecb in these stress tests as you say at
00:10:01
least for now and time will tell yeah all the rest of it but they didn't react
00:10:05
in a way that said oh these these tests were just a fiction no they didn't and
00:10:10
that in itself was a triumph because this was a real really difficult test for the the new european banking
00:10:16
authority this was essentially how you were going to qualify banks to enter the new system
00:10:22
and if it had been a complete softball sort of test and they'd passed everybody as some
00:10:30
europeans thought they would because they argued they'd all been raising capital for a while i think it would
00:10:34
have had no credibility we've sort of seen that that movie before and we know
00:10:38
it ends badly on the other hand they were in a position where if they actually were to fail one of the very
00:10:45
large banks it isn't clear they had the mechanism in place to resolve it because
00:10:52
there really isn't that much funding at the european level and depending on which state it is they may or may not
00:10:57
have enough funding to do it so that's interesting so this was the ultimate curved test in a way they wanted to have
00:11:03
some failures i think they looked the largest was the oldest bank in the world monta
00:11:08
de pescado siena and uh i think their stock dropped 20 percent i think so twenty percent uh that okay um from a
00:11:16
not very high level i would add because it's an already just slightly distressed
00:11:20
level um one of the numbers that was really buried uh in the report but which a couple of analysts did pluck out and
00:11:31
and i i noticed also was this uh something called the comprehensive assessment of the stock of bad loans
00:11:39
they actually call it non-performing exposures we can we call it non-performing loans in the us basically
00:11:45
it's bad loans loans that have a a high chance of never being paid back and you know in that number there's all
00:11:52
kinds that are more or less likely to be paid back i guess that number was really big and
00:11:59
in dollar terms it was uh over a trillion dollars and in fact as they went through the stress tests they
00:12:05
uncovered something like 138 billion more in these non-performing or bad loans than than
00:12:12
the authorities did that is than they thought was was going to be there and um and it's a big number it is
00:12:18
actually uh nine percent of the eurozone's gdp so it's it's pretty big
00:12:25
on the other hand um the authorities said that the bank's capital shortfall was only about 25
00:12:33
billion so i just wanted to find some way of reconciling that big gap so you've got all these potentially
00:12:39
bad loans but they're telling the banks oh you've only got to increase your your
00:12:44
uh you know your your share of money that you're holding on to to account for
00:12:47
that by 25 billion well it it's a little more complicated than that because the
00:12:53
normal process and and by the way it's typical of any bank examination process that examiners will
00:12:59
find assets on the book that they think are not properly valued and they will almost never say something is
00:13:06
undervalued so almost always one of the results is look you've got this many
00:13:12
more assets that we think are dubious and in order to get to a safe and sound position we want
00:13:19
you to accumulate more reserves and that means provisions out of current income so that if these assets should go bad it
00:13:27
won't affect your income or capital so you're sort of anticipating the worst
00:13:32
now these are forward-looking and that's one of the fascinating features of the stress tests
00:13:38
it's a real sea change in the whole attitude toward bank supervision before the crisis virtually all bank
00:13:45
supervision was sort of looking at what we see in today's figures which is kind
00:13:49
of like looking at the future with the rear view mirror these really try consciously to look
00:13:55
ahead uh by forecasting what your position will be under a variety of positions so
00:14:02
the notion behind these assets would be that these assets might well not be paid in full
00:14:10
the number is less than people thought it would be so in that sense uh it was a pleasant surprise people thought it
00:14:17
would be even worse um but in fact depending on the definition they've used and i haven't haven't looked at the
00:14:24
document carefully enough to know but typically you'll start classifying loans
00:14:29
or assets according to how much past due they are and typically in the u.s you'll use a 90-day
00:14:37
period and if they remain not paid for longer than that then you are supposed to allocate more and more
00:14:45
to it so that unless it happens just abruptly by the time you finally have to declare
00:14:51
a loss you will have reserved enough to to be able to absorb it okay those were all my questions is there
00:14:58
anything else we should be covering on this that would be particularly important for viewers well
00:15:04
it all sounds like a within the eu kind of issue that is more than a little technical but we actually do have a lot
00:15:10
riding on it if the european banking system doesn't regain health not only is it a problem
00:15:16
for our financial system but it's a huge problem for the european economy and
00:15:21
they haven't been a significant source of aggregate demand in the world we could hope that they would finally
00:15:27
get there not only for their sake but for everybody else's as well you