Thursday, July 22, 2010

Economics 22/7/10: EU stress tests - what do they tell us, really?

The EU stress tests of the banks confirm the worst fears of all analysts – including myself. The tests were simply a PR exercise, so poorly conducted that no one can have any credibility in their outcomes. Worse than that, the whole circus:
  • The difficulty with which the EU member states appeared to be willing to release information about the tests;
  • The way in which information is being released (via a drip feed – bit by bit over time, with massive leaks beforehand);
  • The struggle through which member states have gone in order to even agree to carry out the tests in the first place;
  • The rhetoric from the EU regulators assigning an almost heroic quality to its efforts to test the banks in the face of a clear shambolic nature of the whole exercise.
All of these things provide for a strong suspicion that the EU will not be able to undertake robust regulation and monitoring of the euro zone banking system in the future, plus a clear cut realization that the entire idea of the euro member states coming together to police their own fiscal behaviour will be even less honest, transparent or robust. In other words, how can we expect the EU to act as a functional policeman of its members fiscal policies if:
  1. It failed to do so over years past, even armed with already robust and automatic regime of the Stability & Growth Pact, and
  2. It failed to properly stress test its own banks?
In the nutshell: German banks, including Landesbanken, have already privately leaked the ‘news’ that they all had passed the test. Ditto for banks in France, Ireland and Italy. Only one German bank – already failed HRE – has failed the test from among 91 institutions.

In the case of AIB – the sick puppy was ‘passed’ by allowing to include into regulators’ calculations the €7.4 billion the bank plans to raise by the end of 2010. Good intentions count for hard evidence, then, per EU regulators. And Bank of Ireland passed - along with all the rest of the PIIGS banks is by the test excluding any possibility of twin shocks - simultaneous continued deterioration in quality of loans and a sovereign debt crisis. Now, in all likelihood, if the sovereign debt crisis continues to rage, does anyone in their right mind thinks that housing and other asset markets in the likes of Ireland and Spain are going to improve to alleviate the loans book pressures?


What the 91 tested banks did ‘pass’ was not a stress test, but a joke, concocted either by those with no understanding of banking (Eurocrats?) or created specifically with an ex ante intent of passing them all. The French and Greek banks privately said that the haircut applied to their holdings of Greek government debt were about 23%. Markets are factoring in 50-70% haircuts, so the EU stress test was less than half as severe as what is being priced already. Worse than that – the sovereign debt haircuts were applied only to bonds held in banks’ trading books. That accounts for just 10% of all Greek bonds held by the euro area banks, as 90% of Greek sovereign debt has been already moved to ‘held to maturity’ parts of banks assets portoflia, not reflected on trading books.

In other words, when it comes to Greek sovereign debt exposure, the EU tests were capturing no more than 5% of the total risk of such exposure for the banks. Like a doctor, looking at the brain activity chart of the patient and saying: ‘Look, there’s no activity at all. But 95% of all other vital signs are performing just fine. Indeed, no worries old man, the patient is still looking 95% alive then…’

And there's more. Per media reports, a memo from Germany's Financial regulator BaFin earlier this year said the real concern should be contagion from "collective difficulties" across the PIIGS, not an isolated default of Greece.

All of this did not prevent Irish stockbrokers from issuing upbeat reports about 'the good news' for BofI and AIB. What good news? The shares in two banks rallied today because someone, somewhere, allegedly decided that if Greece softly defaults, Irish banks will survive? Did that someone actually paused for a second to think, before placing a 'buy' order if Irish banks can survive their own home-made disasters? Or whether they can survive a meltdown of Greek debt default as priced by the markets? Or whether they can survive both happening at the same time?

Irish analysts, who issue these forecasts should be required to read Taleb's 'Fooled by randomness', though one wonders if they will understand much of what Taleb is saying for years now. Investors who chose to belive that AIB and BofI passing of the 'test' this week is some sort of a 'good news' are simply fooling themselves by ignoring a simple fact of life - misdiagnosing a patient with heart attack as being free of an Avian flu is not going to improving the patient's chances of survival. It actually reduces them.

Shamed by this absolutely incompetent, if not outright markets manipulating ‘testing’, you’d think the EU leaders would step back and start an earnest conversation between themselves as to what has gone wrong here. Nope. They are hell bent on creating more Napoleonic sounding, but utterly unrealistic and even disastrously risky plans. This time around – for fiscal harmonization. France and Germany – the two countries that have been clearly at odds with each other in responses to the current crisis have decided that a bout of amicable activism is long overdue. So behold the latest Franco-German alliance on a list of fiscal policy co-ordination proposals.

Per reports in today’s media: a French cabinet meeting took place with German presence, during which Sarkozy called for a complete harmonisation of European tax systems. ‘He did whaaat?!’ I hear you cry… yeah, he did call for that which was explicitly denied by him and the entire EU leadership core as ever having a chance of happening in the run up to the Lisbon II referendum in Ireland.

Now, don’t take me wrong here – this is not a voluntary call for individual states cooperative action – it is a call for an EU-wide ‘reform’. And if you don’t think so, the same meeting called, once again, for member states with excessive deficits to be punished by withdrawal of voting rights in the Council of Ministers, plus a fine and the compulsory imposition of an interest-bearing deposit for member states.

Eurointelligence blog has put it succinctly: “In other words, France and Germany [have called] to continue the same dysfunction regime, except that they strengthen those parts that have prove the most dysfunctional.”

Let me be a tad controversial here - wasn't all of this predicted to happen by Declan Ganley, Anthony Coughlan, Mary Ellen Synon and others who argue in favour of democratic reforms in the EU? Weren't they 'refuted' on exactly these predictions by the entire 'establishment' in Brussels and the all-knowing dons of the Upper Merrion Street? You don't have to agree with their points of view. You might as well agree that the idea of fiscal harmonization is a great thing. But what cannot be denied is that:
  1. Any policies absent meaningful ability to honestly, transparently and effectively enforce them (and EU has shown none of these in its stress tests of the banks - the easiest area to deliver them in current political and economic environment) is destined to be nothing more than a bullying pit for some states to arbitrarily control others; and
  2. Given grave doubts about EU's capabilities to provide for (a), the automatic default option of any new policies should be to scale opportunism and adopt pragmatic, cautious, incremental reforms approach - when in doubt, measure and caution must be the prevalent guide.
After all, if I were a person with the power to shape EU principles, I would adopt the milenia-old medical code of ethics, that is based on the fundamental axiom of morality: Primum non nocere, or First, do no harm.

Then again, adopting such a principle would have meant not conducting these 'stress tests'.


Furrylugs said...

This may divert attention away from sovereign debt and an intergovernmental stress test which might inconveniently reveal the insolvency of a continent. This surreal situation surely cannot escape the attention of the so-called “Markets”.
I can’t believe my brother-in-law is that thick.

Anonymous said...


Seems your jumping the shark here Dr.?

What are your sources for these claims?

All I could find is this >

And there they talk about harmonising taxes between Germany and France only.

And bringing Declan Ganley into this? I respect you and like reading your blog and listening to your analysis on TV time to time

But please dont lower yourself to the level of that US military puppet.

Anonymous S.

TrueEconomics said...

Anonymous S.

Thanks for the comment - my source for tax harmonization being brought up, discussed and agreed for inclusion into new reforms agenda, although not finalized, at the French Cabinet meeting, attended by German authorities is WSJ blog (unfortunately, I don't have a link saved), but here is alternative source:

Schäuble attended the meeting in person...

TrueEconomics said...

As per references to three particular names - I believe in giving people credit.

I try not to mix this principle with my personal views.

I share almost no views in common with, for example Tasc, but I gave them credit before and will always do, whenever they produce good research, such, as for example with their Mapping the Golden Circle report (

It is my personal point of difference with a sad Irish tradition of not citing or referencing or giving credit to the people who make the original point.

Declan Ganley, and others, said before and during the Lisbon I and II campaigns that the EU elites will strive to re-ignite the issue of tax harmonization post-Lisbon. Well, they did turn out to be right.

My personal view - it does concern me that the two largest states in the Union should pursue a clear policy of brinkmanship to drive the harmonization agenda. As an economist, I see no virtue in harmonized tax systems, only dangers.

Let me give you an interesting anecdote - I stress, it is an anecdote. I just returned from a dinner with some Italian friends of mine. They live in a wealthy Northern Italian town, well run, well managed by a popular mayor who is a Communist. They all are middle class and 'left-of-centre' politically.

They are concerned for their kids future because, I quote 'The economy cannot last on 50% tax rates'. I repeat, they are not ideological equivalents of myself - the free-marketeer. They are not business owners (aka greedy profit seekers in Irish Times parlance). They are core socially-conscious typical Italians. And they are concerned that tax rates in Italy are too high - for businesses and people alike - to allow for economic growth.

Does anyone, other than staunch socialists with blinders on their eyes, think harmonizing European taxes at German-French averages will be a great idea?

I certainly gravely fear that Europe will not survive such a policy choice. It will fall apart, sliding into a trade and investment war which will see no winners - only losers, leaving ageing societies unable to tend for their old and to provide any future for their young.

If that happens, China and India and the rest of the emerging world will not feel sad or guilty for Europe's loss. They will not send us aid, or argue in the UN Councils to increase 'humanitarian assistance' to pensionless retirees of Europe. They will take our best entrepreneurial and talented youths and give them work in their economies. The rest of us, well, we'll be relegated to the rubbish heap of history.

Forget all the fancy macroeconometric stuff. If a society cannot afford its old and cannot keep its young, it is a failed society. Just as a failed state, it will cease to exist.

The only way to avoid this denouement for us in Europe is to create a vibrant meritocratic economy based on entrepreneurship, constant competition.

There is no other alternative. For all you hear about the need for public sector, it is private sector that creates the bulk of value added in every economy around the world, save North Korea and Cuba - the two comprehensively failed states. And the private sector that creates this value is the private sector unaligned to state subsidies and supports. The same sector that is being killed off by high taxes (corporate, employment, income, etc - its the overall tax burden that matters first, and its relative distribution across tax heads - second).

Tax harmonization, in my opinion, in current environment, is so dangerous to the future of Europe that I would rather 'jump the shark' and be found to be wrong about its encroachment, than risk being 'safe' to find it a reality of the continent one day.

Many thanks for the comments and thanks for listening to me and reading my articles.


TrueEconomics said...
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TrueEconomics said...
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