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ECB Bank Stress Test, Largely Successful

Oct 27,2014  Market News  Comment: 0

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Philadelphia, Pennsylvania – (StockNewsDesk) – 10/27/2014 — The ECB conducted stress tests on major European banks with 25 banks failing to pass the test, although, they did say that many of these banks had already begun the process of repairing their balance sheets, following discussions with regulators. Despite these failures, markets rallied on the results, as they were better than expected, requiring only 10 billion euros in capital. Additionally, all the major banks in France and Germany passed the stress test with flying colors.

Clearing the Stage for QE?

One often stated purpose and timing of these stress tests are related to rumors that the ECB is on the verge of announcing its own QE style program. However, there are key differences between the US version and the EU version. The US version centered around buying government bonds in an effort to lower interest rates, ease financial conditions, and stimulate lending, business activity, and home purchases.

Due to the EU constitution, as currently constructed, that exact type of program, despite the positive benefits to the US economy, may not be allowable. Thus, ECB chief Mario Draghi is trying to pass a measure aimed at corporate bond buying with the intention to lower borrowing costs for corporations, freeing up for them the ability to spend on research & development, capital expenditures, and hiring.

Of course, for this plan to come to fruition, it requires healthy banks with healthy balance sheets who would be able to support increased debt loads. Basically, there would be an intermediary between the ECB and the debt they are subsidizing. Most of the banks that have failed stress tests were based on weaker economies such as Italy, Greece, or Portugal. However, the total amount of capital required to restore these banks’ status as healthy is a relatively small amount – 10 billion euros.

ECB Bank Stress Test, Largely Successful

Bank Stocks Rally, then Falter

Initially, there was a positive reaction to the stress tests across Europe with the euro higher, stock markets higher, and specific strength in bank stocks. However, after a few hours, the rally reversed on high volume, a telling development. Many market participants are saying that these stress tests or even additional monetary stimulus will do nothing to solve the fundamental issue of a lack of demand in the euro zone countries.

All European related assets have been struggling in recent months and are near 52-week lows. Bank stocks have been particularly weak, especially as lending and borrowing activity has sharply decreased. Compounding these problems are the low interest rates in the euro zone which creates smaller interest rate spreads for banks to profit on.

ECB Takes Over Monitoring

The stated reason for the stress tests was the ECB is taking over bank supervision from individual countries regulating their banks. An investor survey revealed that they expected almost half of banks to fail the stress tests, requiring 51 billion euros in capital raising to repair balance sheets. The differential can be interpreted by the bulls as banks being healthier than thought or by bears as the stress tests lacking merit.

The hope is that this, on its own, will encourage banks to embark on riskier lending. One of the aftershocks of the crisis has been for banks go into a risk adverse mode and avoid any type of risk at all. While this behavior is rational for any individual bank, when all banks do it at the same time, it creates problems for the economy and prevents any type of recovery. Based on the action in bank stocks, investors remain unconvinced that these are meaningful.

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