European Stress Test Too Easy

Jeremy Glaser: I'm Jeremy Glaser with Morningstar.com. The results of the European bank stress test were released today. I'm here with Senior Banking Analyst, Erin Davis, to take a closer look.

Erin, thanks for joining me.

Erin Davis: It's good to be here, Jeremy.

Glaser: So, first off, what was the stress test? What was Europe looking at?

Davis: Well, they put together a list of economic indicators that would be present in an adverse scenario and how the banks might perform under those scenarios. There was the base scenario and then the more adverse one. And it was – it incorporated a mild recession in 2010 and 2011. And then on top of that they also considered what would happen in Sovereign's bonds stressed case, which isn't the same as a default, it's more like what happened in May that the bond prices become deeply depressed.

Glaser: Basically, they wanted to see if things got worse than they were right now, how would these banks perform, would they need more capital, or would there be lots of banks that would go under.

Davis: Yeah, that's it, exactly.

Glaser: So, what were the results?

Davis: Well, 84 of the 91 banks that they tested passed. Which is a very good result, that's – it's higher than we expected. It's higher than most of the analysts expected. And moreover, of the seven banks that failed, they only needed $3.5 billion of fresh capital, which is a lot lower than we would have thought.

Glaser: So, given that this seemed like pretty good news from them, you know, are there any maybe potential pitfalls in the actual way the test was administered that could mean that there actually is more stress in the system than the report revealed?

Davis: Well, I think that anytime you see a test with a really high pass rate, you have wonder whether it's just that the test is a little bit too easy. And we think that that's the case here. We would have liked to see a more stringent test. There were a couple of areas where we think that the test could have been more difficult, and might then have more clearly answered investors' questions.

Glaser: What were some of those areas?

Davis: Well, the most glaring deficiency is that the test didn't include the possibility of a sovereign default. What they talked about was more like just if the bond prices became very low, but not if Greece, for example, actually said that it wasn't going to be able to pay its bondholders in full, and banks hold a lot of government bonds and if that happened there could be a lot of banks both in the countries that might default and in countries that have subsidiaries there that could be in very big trouble.

Glaser: And was there anything else you think the test really could have covered in a stronger way?

Davis: The other thing that I see about the test is that in some ways they're very similar to the U.S. stress test and maybe even a little bit harsher. And the barrier to pass the test was that banks had to have a Tier 1 capital ratio of 6%, and that's the same as in the U.S. But in the U.S. there is a second test, and that was whether or not the banks could maintain a 4% ratio of common tangible equity to risk weighted assets, and that it was actually the stricter test in the U.S. stress test, and the European banks didn't have any sort of bar like that that they had to jump over. And that means that even though they maintained reasonably good capital ratios some of that capital may not have been of very high quality and wouldn't really be able to absorb losses in a real downturn.

Glaser: So, there really could be more downside than the test actually foresees?

Davis: Yeah, that's definitely true.

Glaser: Now, the U.K. actually is growing a little bit faster than people had initially expected. Is there a chance that we'll see growth in the rest of Europe and that recovery will kind of make all of these tests move point?

Davis: Yeah, I think that that's definitely what stockholders are hoping for. If the adverse scenario or the worsened adverse scenario never comes to pass then I think that we'll see that the stress test will be fairly effective, because they've answered some of the medium worst fears and have shown that their banks are in reasonably good shape.

Glaser: We'll definitely give something for investors to think about.

Davis: Indeed.

Glaser: Erin, thanks for talking with me today.

Davis: It was good to be here, Jeremy.

Glaser: For Morningstar.com, I am Jeremy Glaser.