The European central bank (ECB) has conducted bank stress tests in the past, and it missed the mark entirely by using rosy scenarios that couldn’t help detect anything wrong. Let’s just recall that the irish banks, or Dexia, had passed those tests with flying colors just a few months before going bankrupt. But this time, the ECB and the EBA (European Banking Authority) are telling us that things will change, that the criteria will be more rigorous, that they will not hesitate in naming banks having problems and that they will not be hanging out gifts.

However, as we learn in this note from Natixis (a bank that was close to bankruptcy but has a decent study department), a close look will be taken at the bad loans… without taking into account sovereign debt! Notwithstanding the fact that banks are holding major amounts of it and that any hike in interest rates would bring considerable financial losses, it will not be counted.

On the bad loans front, things are already shaky. In Italy and Spain, the default rate on both household and business credit is up since 2008, and the trend is picking up. But on top of that, the amount of public debt owned by the banks has gone from 12% in 2008 to 28% today, in Italy, and from 7% to 30% in Spain over the same period. This could be enough, on its own, to explode those countries’ banking systems should interest rates rise significantly. But the ECB has decided to keep its eyes closed…

ECB

The Natixis study tries to evaluate this risk : A rise of only 1% in interest rates would cost 28 billion euros to the italian banks, or 16% of their own funds, and 20 billion euros to the spanish banks, or 12% of their own funds. Only 1%, and the alarm bells are sounding…

Why is the ECB acting this way? We’re here at the heart of the conflict of interests that we have denounced in the past, e.g. the central bank being the banking sector’s regulatory organism : the ECB is judge and party. Because the ECB is responsible for the behaviour of the Eurozone’s interest rates. It set its base rate at the lowest, 0.25%, and generously lends to struggling banks (two LTROs for 500 billion euros each, and many other types of aid). Any rise in interest rates in southern european countries, or in France, would bring its failure, thus it refuses to let it happen.

The ECB, just like the Fed and the BoJ, is stuck : Either it keeps buying government debt indefinitely (even if indirectly, for the ECB), which will lead to hyperinflation, or it stops monetising the debt, which will lead to a rise in interest rates that would bring about bank failures and a severe depression. In both cases, savers will be punished, of course. So, in the mean time, they’re trying to save face, and that includes running rigged stress tests.

Philippe Herlin – Researcher in finance and junior lecturer at the Conservatoire National des Arts et Métiers in Paris / Contributor on Goldbroker.com

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