Reaction to the Latest EBA Stress Tests

At times it can be difficult to decipher and interpret new information quickly and a period of reflection is required to reach a considered point of view. At the end of last week, the results of the latest European banking stress tests were published. This is only the second time such results have been made available, with the first set of results widely derided as too narrow in focus, sparking criticism for not providing anywhere near enough detail. However, in general, the market’s reaction to the first European banking stress tests was positive.

The release of the latest European banking stress tests, which were published at 5pm on Friday 15 July 2011, evoked a similar, positive initial response, with a jump in both the euro and the American stock market. This was due to the headline number of a relatively small number of banks that had failed the test.

However, as is often the case, the devil is in the detail. While it was clear beforehand that once again the criteria for passing was too narrow, and more importantly the points of stress where fixed far too low in relationship to current market yields in the peripheral sovereign debt, it is the information that banks were allowed not to disclose that is poignant.

It was stipulated that no banks had to disclose any holding to commercial debt in any one country that was less than 5% of their total loans. It’s worth remembering that many of the larger banks have a far greater exposure to commercial debt than sovereign debt, so allowing them to not fully disclose simply adds to market uncertainty. Due to the large size of many European banks, this amplifies the markets anxiety. This was clearly seen last week in the partial paralysis in LIBOR. To place into context, Lloyds Bank only had to disclose its UK and US exposures.

Having now had a weekend to ruminate, the market’s reaction is clear. The euro is back under pressure and peripheral yields are already rising. Once gain policy makers have missed an important opportunity and the market has already discounted the stress tests credibility and importance.

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