Only seven banks out of nearly 100 failed the European stress tests around two weeks ago. Yet, the question still remains whether the test has done enough to ensure the strength of European financial institutions.
The only real result of the entire exercise thus far seems to be that the watered-down stress tests in Europe have underscored a fundamental lack of confidence in the banking system across the proverbial pond. Indeed, investor jitters in the run up to the tests -- arguably created by the test itself -- are not subsiding.
The banking sector's perceived/continued fragility has made a significant contribution to the recent bout of financial market volatility. Investors have become increasingly concerned that bank balance sheets remain vulnerable to shocks -- a reasonable assumption, given the tumultuous experiences of the past three years. And that concern may very soon extend back towards America's financial behemoths, too, as the effects of recent financial reform legislation begin to come to light.
The Financial Stability Act, now known simply as Dodd-Frank, establishes the Financial Stability Oversight Council
. This council, as part of its congressional mandate, will oversee yearly stress tests on U.S. banks in order to measure credit exposure limits, according to the Federal Reserve Bank of Philadelphia
. These stress tests will be subject to credit exposure limits. A House-passed provision added to Dodd-Frank will also require banks to maintain a leverage ratio of 15 to 1. What's more, the council will also have the authority to place a systemically important financial institution under the supervision of the Federal Reserve
. Non-bank institutions may also be required to divest holdings.
After the European bank stress tests, the Association for Financial Markets in Europe
had this to say: “This information goes some way to helping investors understand the underlying strength of individual banks and make their decisions accordingly. But direct comparisons between banks that have been assessed using differing criteria should be made with caution. These results do not, and should not, create a ‘league table’ of European banks.”
As if regulators could do anything as simple as classify banks in a league table. Instead of providing a laundry list of accomplishments, stress tests achieve the opposite of what's ultimately really needed in today's economic environment.
In another AFME release on the SEC's growing role under Dodd-Frank, the trade group warns that without flexibility to reflect local non-US parties, regulations, transaction structures and product types, many European participants are likely to struggle to comply with the new rules, resulting in an uneven playing field. "Inconsistencies between European and U.S. regulations raise the cost of the compliance burden," the release read. "For example, risk retention requirements are not the same, and the limited use of 3rd party servicers in the European market makes compliance with reporting requirements more difficult."
Furthermore, audit giant Deloitte
is now asserting that capital requirement changes under Basel 3 could trump requirements tied to Dodd-Frank. So will these coming stress tests bow to Dodd-Frank or Basel 3? Or something else? What standards will banks such as Barclays
need to follow?
Well, one way or another, the answer is all of them.
This should be a real concern, because neither standard truly represents an overhaul of the issues that created a global recession (depression?) in the first place. Additionally, the new Financial Stability Oversight Council will likely be less than uniform in administering and applying these levels of standards, as it looks to make its name in the newly-minted field of stress testing.
Make no mistake, America's banks are well aware of this and already preparing to conduct reverse stress tests in order to be able to provide the necessary information to regulators in a timely manner. But Deloitte also sounds a warning on this, noting that "it is likely that [the regulator] will continually shift demands as it monitors different aspects of risk in the financial system."
Deloitte also suspects the regulator will begin asking banks for "living wills," in case the Fed needs to step in.
But these developments will do nothing to remedy to inherent sense of unease that stress tests currently create to begin with. The Securities and Exchange Commission
still does not differentiate between covered bonds and securitization in structured finance regulatory framing. Europe's banks are still not factoring exposure to sovereign debt levels in the run up to these tests.
So unless these stress tests are meant to provide something much larger than the creation of more stress, then it remains unclear not only what making the grade really means -- but who in the end gets to pass.
Jacob Gaffney is the editor of HousingWire.
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