After recently wrapping up a round of stress testing on European banks in October, the European Central Bank determined that most banks would be able to brave a decline such as the recession of 2008, or worse.  Unfortunately, after looking at the stress test parameters, analysts determined that European banks maybe are not as safe as previously thought, in the event of a downturn.  According to the Danish Institute for International Studies, the ECB did not take into account new leverage minimum rules that will go into effect starting next year.  The new bank law requires that banks have 3% of total assets (aka leverage ratio) in cash to help take some of the risk off and stabilize the banking institution in the event of a downturn economy.  If the ECB had tested for this new parameter and high credit quality, they would have found that 28 banks that had passed the ECB’s stress test would fail under the banking laws to come into effect next year.   Additionally, the modified stress test revealed that Europe’s 12 largest banks still need to raise another $82 billion (66 billion euros) in order to be deemed “safe” in the event of a recession.

European Banks Not As Well Off as Stress Test Suggested

ECB chose to leave out new leverage ratios in the European banks’ stress test

In response to these finding, the ECB stated that they chose to leave out new leverage ratios in the stress test because “European lenders only have to report those numbers on an informational basis starting next year” (Bloomberg).  While the ECB is scrambling to cover itself and explain why they chose to leave out leverage ratios, a 2012 Bank of England study has proven the importance of including the leverage ratios in a stress test.  In fact, they found that basic leverage ratios were overall, more predictive of bank failures than risk ratios.

After conducting the updated stress test, it was found that Deutsche Bank AG (NYSE:DB) (ETR:DBK), BNP Paribas SA (ADR) (OTCMKTS:BNPQY) (EPA:BNP), Societe Generale SA (ADR) (OTCMKTS:SCGLY) (EPA:GLE), Groupe BPCE, and ING Groep NV (ADR) (NYSE:ING) all saw leverage ratios fall below 3%.

European banks: ECB did not accurately test for the full spectrum

The bottom line here is that the ECB did not accurately test for the full spectrum of an economic slowdown.  Several of the largest German, French, and Netherlands banking institutions were found to have insufficient funds to begin lending and normal banking operations again after a recession, which certainly adds to the length and severity of the recession, as we saw in 2008 when no banks were lending.  Overall, now is not the time to ease up on restrictions on capital and tier 1 credit because someday there will be another recession and the ECB is doing themselves, Europe, and the world economy a disservice by not properly preparing these institutions for the inevitable.   In the end, more work needs to be done and a bigger safety net needs to be cast by bank leaders to avoid another round of bank failures and bailouts.

Disclosure: None