While having to put another €24 billion into the banks is hard to stomach, I am still surprised by the overwhelming negativity in the reaction to the release of the stress test results. I think there were three big questions going into yesterday:
(1) Would we get the information necessary to reduce the large range of uncertainty about ultimate banks losses that has been weighing so heavily on the creditworthiness of both the banks and the state? The detailed information on bank balance sheets and projection assumptions used allows anyone interested to reengineer the calculations as necessary, and is a step change from the kind of information analysts were working with before. The bank balance sheets and loan loss projections are now far less of a black box.
(2) Would the banks end up sufficiently well-capitalised to overcome the difficult funding environment? By my calculations, allowing for the capital buffers, Core Tier 1 is close to 10 percent under the stress scenario and close to 17 percent under the base scenario. [Note that the stress scenario is binding for all four tested banks this time round; see Table 16] We will have very well capitalised banks.
(3) Would the tests produce something close enough to a credible upper bound on bank losses? Given the pessimism underlying the stress scenario and the additional prudential buffers, the tests have gone a long way to achieving this credible bound. Yet many commentators prefer to stick to their own back of the envelope-type loss projections.
Of course, the stress testing and associated recapitalisation is just one step – albeit a hugely significant – in the process of regaining creditworthiness. Another is to have a reliable lender of last resort. We got a strong signal from the ECB yesterday that liquidity support will continue, which is critical to the retention and expansion of deposits.
Unfortunately, we continue to have a significant problem with state creditworthiness, which itself feeds back on the creditworthiness of the banks. It is extremely difficult to have creditworthy banks if we don’t have a creditworthy state. Even the existence of a reliable lender of last resort is hard to secure without a creditworthy state that can absorb losses over the longer term.
I think the nature the state creditworthiness problem is being widely misdiagnosed, however. While we are not out of the woods on perceived debt sustainability, the reduced uncertainty associated with yesterday’s tests is a big step forward. Assuming we can see through the fiscal adjustment and get a half-decent outcome on growth, we should be able to stabilise the debt-GDP ratio somewhere around 120 percent.
Another issue is market access at a high (if stable) debt ratio. Understandably enough, the “renegotiations” over the bail out focused on the Ireland-specific elements, notably the interest rate and prohibitions on burden sharing with senior bank bondholders. But I think the bigger problem is with the design of the post-summer 2013 permanent bailout mechanism (ESM). Today’s potential investors worry that Ireland will not have market access given the burden-sharing and official creditor seniority features of the ESM. They thus surmise that Ireland will need another programme. Part of the conditionality of such a programme is likely to be a “bail-in” of existing bondholders, which could be brought forward in time as it comes to be viewed as inevitable. No investor today – or a year from now – will want to get caught up in such a mechanism. We thus get the kinds of risk premiums we see here.
So what do we do if European governments persist with this self-defeating design? We may simply have to live with it, accepting that we will be out of the market – though receiving official support – for an extended period of time. The hope is that as growth, bank losses and fiscal adjustment fall into place, we will be able to turn market sentiment around even with the ESM. Philip Lane notes the outturn on the different elements will not be clear for some time, and wisely counsels to sit tight while meeting programme conditions.
Of course, it is possible that debt restructuring is eventually required along the lines noted above. Provided we are meeting our support conditions, such a restructuring should be more towards the “excusable” end of the spectrum in terms reputational damage. (Karl Whelan takes an even more positive view of this bail-in scenario; see the exchanges on an earlier thread on the ESM.)
(If I understand him correctly, Colm McCarthy is arguing for a European-sanctioned solution that puts losses on bank bondholders, including potentially guaranteed bondholders. Colm sees the reputational damage from defaulting on the state guarantees is less than the damage from defaulting on state bonds. I am not so sure; and think the reputational damage of default – should it have to occur – is likely to be minimised if we stick to the process being prescribed by the official creditors.)