July 13, 2011

Bankmageddon: All Eyes on Europe as Bank Stress Tests Loom

Signs that banks are less willing to lend to one another raise specter of Euro-Lehman crisis.

Private investors, bankers and finance ministers alike will be closely watching Friday’s release of Europe's bank stress tests.

The European Banking Authority (EBA) pledged a transparent look at the credit vulnerabilities of 91 large banks comprising 65% of the region’s banking assets. A similar report in 2010 drew criticism when the Irish banks that had passed the test later imploded, forcing Ireland to seek emergency EU and IMF bailouts. The EBA said in a statement that it sent additional guidance to banks last month in an effort to “address shortcomings and over-optimism of some banks’ preliminary estimates.”

The tests seek to assess whether the banks could survive adverse conditions such as a worsening economy or an unexpected default such as occurred with Lehman Brothers in 2008 in an “effort to improve transparency, identify vulnerabilities, inform policymakers and ensure appropriate measures are taken to address possible deficiencies,” the EBA says. To that end, the EBA will simultaneously announce corrective measures recommended for institutions deemed at risk.

Concern for the financial health of European banks has intensified this week as bond vigilantes put the screws on Italy. Ten-year-government bond yields on the debt of Europe’s third-largest economy surpassed 6%, the point at which many financial experts believe debt-service costs begin to spiral out of control.

Bloomberg quoted Fitch Ratings as saying the yield jump reflects a “crisis of market confidence in the European policy response to the euro-zone debt crisis rather than deteriorating sovereign credit fundamentals,” and assured investors Italy is “on track” to meeting its budget deficit cutting target for this year.

Despite the reassurance, signs of credit contraction recall the period after Lehman Brothers’ collapse when U.S. banks refused to lend to one another. A report in The Wall Street Journal cited defensive moves by European banks to limit their exposure to contagion by shaky European countries and the banks that own their debt.

The Journal reported that banks are becoming wary of lending to one another and cites data showing they are placing more funds with the European Central Bank and increasing the use of credit default swaps against their holdings of sovereign debt.

While Friday’s stress test results should clarify some of the obvious risks such as which banks hold toxic Spanish mortgage debt, a key unanswered question might be the identity of institutions writing credit default swaps -- the insurance -- against-default agreements that brought down AIG.

Exposure to Europe’s sovereign debt is far reaching. France and Germany have been seen as relatively healthy economies at Europe’s core. Yet French banks own $389 billion in Italian debt alone and German banks own nearly that much ($344 billion) in Italian and Spanish debt combined. Debt for just those two countries held by all European banks totals nearly $1.5 trillion.

This exposure could push vulnerable European banks over the edge. A report released this week by the Bank for International Settlements (BIS) noted that higher sovereign risk since late 2009 has already pushed up bank funding costs and weakened institutions and concludes that “elevated sovereign risk premia are likely to become a persistent feature of the financial landscape.” This trend will continue to exert pressure on banks’ balance sheets, and if not managed well by policymakers, could lead to another panic and credit contraction.

The BIS report concludes: “Advanced country governments should try to move as quickly as reasonably possible to implement credible strategies to stabilize or reduce their debt levels.”

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