Stress-testing the banks. A difficult balancing act

The European Central Bank is becoming the singe supervisor of the large and medium-sized banks in the Eurozone. Before taking on this responsibility it was important for the ECB to be well informed about the health of the Eurozone banks. This health report was released last Sunday.

What is most striking is that relatively few banks failed the test, i.e  only 14 out of 130. That is quite a success. Was the exam too easy? At first sight this does not seem to be the case. The ECB examined, for example, what the effect would be of a decrease of GDP by 5% spread over two years on the value of the banks’ assets. That is quite a steep recession, comparable to the one that hit the Eurozone in 2008-09. Of course, the ECB could have investigated more pessimistic scenarios. For example, it could have asked what would happen if a new crisis erupted in the government bond markets? The ECB investigated only mild increases (2 to 3 percent) in the government bond yields. During the period 2010-11, these increases were much larger, reaching 10 percent or more. Should the ECB not have been tougher and simulated more intensely negative economic shocks?

This is like asking how pessimistic a central bank should be? There are negative scenarios that are so unfavorable that not even half of the banks would survive these. A new debt crisis like the one we experienced in 2010-11 is such a scenario. Such a negative scenario is not even very unlikely. But should a central work out the consequences of a disaster?

The ECB walks on a tightrope. An overly pessimistic scenario that would lead to the conclusion that more than half of the banks are at risk would be the equivalent of a terrorist suicide attack.  The publication of such a scenario by the central bank would lead to an immediate banking crisis. A central bank that cares about financial stability should not place a bomb in the market place. The ECB has not done so.

Yet the ECB did not fall into the other extreme. It did not let all the banks pass the test. Fourteen banks failed. This is not a high number. But neither is it a ridiculously low number that would have harmed the reputation of the central bank. The ECB carefully considered how far it could go in balancing the need to maintain financial stability with the desire to keep its reputation intact. The ECB seems to have succeeded in this balancing act.

Should we expect that the bank stress-test now is the beginning of a new era and that banks will be willing to expand bank credit, as the Vice-President of the ECB, Vítor Constâncio, suggested? This is highly unlikely. The depressed nature of bank credit today has much to do with the fact that economic activity in the Eurozone has slowed down again. As a result, the demand for credit by firms and consumers remains low. In order to overcome this, it will be necessary to stimulate aggregate demand. The best way to do this is by increasing public investment.  Put differently, the stress-test was necessary to create the conditions for banks to start lending again. But such an increase will only be possible if the Eurozone ends the period of austerity and starts stimulating investment again.  Unfortunately, the resistance towards fiscal stimulus is the highest in those countries that face the least financial constraints to engage in such policies.