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Have we not heard it all before? The bank stress tests are not sufficiently transparent, the conditions are too soft, and nobody knows who will put up the financing for necessary recapitalization of weak banks. But after the US bank stress tests were published on May 7, 2009, the Wall Street Journal announced: "Worst-Case Capital Shortfall of $75 Billion at 10 Banks Is Less than Many Feared; Some Shares Rise on Hopes Crisis Is Easing." A massive stock rally started that lasted for months.
Frankly, there are plenty of reasons to expect something similar after the publication of the European bank stress tests on July 23. Markets hate uncertainty, and that day they will receive sufficient information, and the cold numbers are likely to be reassuring. A reasonable guess is that the need for European bank recapitalization will be about twice as much as for the United States–on the order of $150 billion, and heavily concentrated in Spain and Germany.
The US stress test involved only 19 banks, which reflects the great concentration of the US banking system. The European stress test covers 65 percent of European banking assets. But because of the much smaller bank concentration, it involves no fewer than 91 banks. The selection of banks appears astute. No fewer than 27 (!) Spanish banks and 14 German banks are included, but no more than 6 from any other country. It focuses on the places where the greatest problems are likely.
Europe is following the example of the United States in May 2009 of washing its dirty linen in public, which then turned out not to be all that badly soiled. The US bank stress test was the start of the US recovery. In the same way, Europe is likely to recover after its stress test (which should have come earlier).
Similarly, when the stress test results are out, the need for recapitalization will be evident and therefore it will be pragmatically resolved. My guess is that $150 billion is not all too much. Say, for example, that governments will finance 60 percent (Spanish cajas and German Landesbanken), and the rest will be covered by private investors. This should be an opportunity for Spanish and German leaders to raise public confidence. The obvious conclusion is that the European banking crisis will be contained! The Japanese conundrum of eternally murky banks will be avoided.
In parallel, Eastern Europe is now balancing its current accounts (the Baltic states already have large surpluses, Central Europe is in balance, and Romania and Bulgaria have limited deficits). The PIIGS [Portugal, Ireland, Italy, Greece, and Spain] are undertaking a major fiscal adjustment, as they should, and the rest of the European Union is carrying out a limited fiscal adjustment as its members should. The United States should welcome these fiscal and current account adjustments. To ask countries with 80 percent of GDP in public debt (such as Germany and France) to pursue fiscal stimulus is neither intelligent nor responsible. The big US message should be that Europe is adjusting in a nearly ideal fashion.
A long-term deleveraging is inevitable after this long credit boom. A deleveraging usually lasts one or two decades and reduces growth—for example from 1874–96. But substantial growth is still possible in the current environment. A slowdown cannot be averted, but neither is it anything to worry about. To argue that the United States should stimulate its own problems away is neither credible nor sensible.
One of the most important consequences of the European bank stress test will be that the European Union is coming together in many ways. First, this stress test will be applied to the EU of 27 and not be reserved for the eurozone of 16. Second, it is being carried out by the EU Committee of European Banking Supervisors (CEBS), which is a loose and newly-formed institution pertaining to the European Commission, which will be reinforced by the stress test. Third, CEBS will soon become the European Banking Authority, which is an all-EU banking inspection that was missing before the crisis. That means that the European Union is finally obtaining an all-European banking inspection regime. In parallel, all-European inspections for insurance and security markets are also being formed.
When looking back on the European bank stress test on July 23, 2010, we are likely to note that it led to the second recovery after the great recession of 2008–10, and that it even more importantly reinforced all-European financial institutions.
