The bank stress tests were completed and announced
earlier this week by the European Central Bank (ECB), and organized by the
European Banking Authority (EBA). Of all the European banks that were tested,
25 failed to pass, of which half have taking steps to remedy the problem. As for
the Greek banks, two did not pass. They are Eurobank and National bank. After
the announcements, the bank of Greece (BoG) expressed its dissatisfaction,
saying that the banks have covered the necessary capital needed. Spanish banks
performed better than expected while Italian banks fared the worst.
The stress tests were conducted on the banks’ balance
sheets as of December 31, 2013, to determine the value of their assets, like
loans. The value of the assets will depend on the ability of the people who
took out loans to repay them. Also, to examine the value of collateral put up
to receive the loans.
The findings by the ECB are that banks in the European
Union had given out loans worth 136 billion euros, and are in red, bringing the
total to 879 billion euros($1.1 trillion). From the data, Italy has 12 billion
euros, Germany 7 billion, and Greece 8 billion, to implement. Since many banks
had the feeling that they were not going to meet the tests, they rushed to
increase owners’ equity. Greek banks did just that, either raising additional
capital from shareholders, or selling off subsidiaries so as to raise cash. The
results are that Greek banks show a surplus of 4.5 billion euros due to the
actions taken. Also the results do not show the deferred taxes, which is
included in the results of the Italian, Portuguese and Spanish banks. This is
estimated, will enhance the capital base of the Greek banks (there are only
four in the nation) by 2.5 billion euros. Eurobank shows, according to the
tests, a capital need of 1.75 billion euros, and National bank 930 million. As
for the management of the two banks, they said that the capital shortage will
be covered by the profitability of the nine months results, and the addition of
deferred taxes.
The stress tests in financial terminology is a
simulation designed to determine the ability of financial institutions to deal
with an economic crisis, so as these financial institutions could handle any
macroeconomic crisis, and thus, not in need of a bailout by the taxpayers.
These were risks like market risk, liquidity risk. The IMF says that these are unlikely
but plausible. If one looks at the financial crisis in the US I think it is
more than likely. The idea is to see if these financial institutions have ample
cash or assets to withstand these risks, and cash reserves do not sink to
levels where the only escape would be a collapse.
These tests of financial instruments on the balance
sheets of the banks may include the effects of the unemployment rate, a
financial market crash similar to that of the United states, which prompted the
financial crisis, an increase in interest rates, a drop in GDP, an oil price
rise, or if half of the assets in a portfolio
drop.
Stress tests were first started in the 90’s. In 1996,
under the Basel Capital Accord, was amended to require financial institutions
to conducts stress tests. The purpose was to see their ability to respond to
market shocks.
Guidelines can vary as to the tests. In 2012 when the
Federal Reserve conducted stress tests had an aim at banks with assets over $10
billion. The amount that they determined banks should have on reserve was based
on outstanding debts and assets. Credit and market risks are two very important
factors affecting banks’ profitability and solvency, due to potential losses
from default on the loans.
A bank’s portfolio is measured by market risk.
Interest rates, exchange rates, and prices of financial instruments and bond
prices, can affect the value of assets in a bank’s portfolio. Also what impact
can it has a likelihood of a bank run.
There was some criticism on the stress tests but that
I personally found very worthwhile mentioning is the issue of deflation.
Deflation is the opposite of inflation, and is where a country experiences
lowering prices, everything becomes cheaper. But when it drags on for a while,
as in the Eurozone, then companies’ profits decline, excess supply forces
companies to sell their stock even cheaper, wages are reduced, production costs
are cut, and employment rises.
Deflation is caused by a reduction in the supply of
money. And this can be seen from the fact that banks have stopped to give out
loans. Greece is an example. From the positive results of the stress tests,
Greece will save 11.4 billion euros, and now it contemplates as to how to
utilize this money since it remains intact in the Financial Stability Fund. One
thought is to use it to pay off the debt.
A persistence decline in prices creates a spiral of
falling prices and profits. Japan went through this in the 90’s and lasted for
years. The government lowered interest rates to cause consumption, and thus
inflation but to no avail. The policy ended in 2006.
