The Committee of European Banking Supervisors (CEBS) released the much anticipated results of the EU wide banking stress test exercise this afternoon.  Seven banks failed the stress test and will require a combined total of €3.5 billion of new capital.  The results are being met with some skepticism regarding the nature of the “adverse scenario” used by the examiners as well as the fact that the stress tests do not explicitly account for the possibility of sovereign default.  In light of the uncertainty in the overall economy as well as the situation in Greece, the stress tests may fail to provide much reassurance regarding the stability of Europe’s banking sector.

Macroeconomic Assumptions

According to the summary report (pdf), two sets of macroeconomic scenarios were used:  benchmark and adverse.  The benchmark scenario was based on the EU Commission’s Autumn 2009 forecast and the European Commission’s Interim Forecast made in February 2010.  The adverse scenario was based on European Central Bank estimates.  The study period included 2010 and 2011.

The benchmark scenario assumes a “mild recovery” from the downturn of 2008-2009 while the adverse scenario assumes a “double dip recession”.  However, the “double dip” scenario is very mild:

For the euro area, the GDP growth under the benchmark scenario is assumed at a level of +0.7 (2010) and +1.5% (2011), whereas under the adverse scenario the euro area would see a decrease of GDP by -0.2% in 2010 and -0.6% in 2011. For the whole European Union (EU27) the benchmark scenario assumes a +1.0% growth of GDP in 2010 and +1.7% in 2011, whereas under the adverse scenario the GDP would not grow in 2010 and would decline by -0.4% in 2011. On aggregate and over the two-year time horizon, the adverse scenario assumes a three percentage point deviation of GDP for the EU 3 compared to the benchmark scenario.

With the “adverse scenario” only accounting for flat GDP in 2010 and a mild -0.4 percent decline next year, the question that is on everyone’s mind is what the stress test results would look like in the event of a more severe recession that shrinks GDP by 2 to 4 percent.  In a Q&A document (pdf) provided by the CEBS, the examiners attempt to address the question of whether the adverse scenario is a substantial enough stress.  Here is an excerpt from the statement (Question 26):

The adverse macroeconomic scenario incorporates prevailing tail risks, especially related to the sovereign debt situation; in particular, it implies that real GDP growth in the EU would be substantially lower than in currently available forecasts – on average by some 3 percentage points cumulated over 2010 and 2011 implying a recession both in 2010 and 2011. This scenario has a very low probability of occurring. Coinciding with a recession, the adverse scenario implies significant increases in interest rates, which are unlikely and are assumed only for the purpose of building a stressful scenario.

Perhaps the adverse scenario selected by the examiners has “very low probability of occurring” but that seems somewhat beside the point if the intent was to demonstrate substantial soundness of the European banking sector.  The reader of the report is left to question what the results of the test would have been given a more severe contraction in 2011.  What would the results have been if the assumption was even a 2 percent decline in 2011 rather than a 0.4 percent decline?

Sovereign Default Risk

While the adverse scenario does consider “sovereign risk” modeled as an increase in government bond spreads which would pressure the banks, there is no consideration of sovereign default.  In question eight of the Q&A document, the examiners make the following statement regarding why sovereign default was not explicitly considered:

The setting up of the European Financial Stability Facility (EFSF) and the related commitment of all participating member States provides reassurance that the default of a member State will not occur, which implies that impairment losses on sovereign exposures in the available for sale and held-to-maturity in the banking book cannot be factored into the exercise.

Essentially, this statement simply states that member states have provided “reassurance” that no default of a member state will occur and therefore the possibility of default was entirely ignored in the test design.  Surely this is not a reasonable assumption if the goal is to examine possible scenarios that are reasonably likely to occur over the next several years.  While the EFSF provides more time for troubled states like Greece to address its dire fiscal situation, it does not follow that default risk is somehow eliminated.  Essentially, the examiners are saying that member states will be bailed out in perpetuity, but this has no credibility given that the political will to provide limitless funds does not exist, particularly in Germany.

Unlikely, But not Impossible

The point of these observations is not to suggest that Europe’s economy will contract by more than 0.4 percent in 2011, or even that it will contract at all.  Indeed, positive economic news in recent months has increased the confidence of many economists who are anticipating economic growth to continue.  However, if the purpose of the EU banking stress test was to provide reassurance to investors and others regarding the European banking sector, the stress tests should have gone further in the adverse scenario assumptions.  After all, if a bridge is designed to accommodate a maximum load of ten tons, engineers make sure that it can handle a considerably greater load as a margin of safety.  Due to the relatively benign “adverse scenario” assumed by the CEBS, we are left to wonder about how much of a margin of safety actually exists in the banking sector.