Banking recovery?

Fears of a new banking crisis were soothed this week after banks borrowed less money than expected in two closely watched European Central Bank (ECB) tenders designed to ensure banks have sufficient liquidity. Now attention is shifting to so-called stress tests some banks are undergoing to see if they have the wherewithal to withstand future crises.

Some analysts are interpreting the relatively low borrowing this week from the ECB as a sign that banks have weathered the worst of the financial storm of the past two years and are on the road to recovery, albeit a slow one.

"I think it does indicate a certain easing of tension in the banking sector," Falko Fecht, a professor of economic and banking policy at the Wiesbaden-based European Business School, told Deutsche Welle. "It points toward a recovery, although there are still risks."

The ECB said that on Wednesday, 171 banks borrowed a lower-than-expected 131.9 billion euros ($165 billion) for three months. Then on Thursday, in another special auction, 78 banks borrowed 111.2 billion euros ($136.7 billion), just before a record 442 billion euros in 12-month ECB loans came up for repayment that the central bank had made at the height of the crisis.

The result of the three operations means that the ECB has reduced the amount it is lending to eurozone banks by about 200 billion euros.

The ECB is reducing the length of loans to commercial banks to gradually normalize conditions, but it is still providing cash to banks to keep credit flowing through the wider economy. The financial crisis froze up interbank lending as banks began to fear partner institutions would default on loans in the wake of exposure to so-called "toxic" assets and the resulting huge losses.

Skepticism

However, not everyone is convinced that the banking sector is firmly back on the road to rosy-cheeked health.

Franz-Christoph Zeitler, vice-president of Germany's Bundesbank, warned against misplaced euphoria, describing the state of the banking sector as "fragile."

Manfred Jaeger-Ambrozewicz of the Cologne Institute of Business Research also says banks are not out of the woods yet, adding that a rash of relatively good news on the financial front, including higher growth estimates in Germany, have put some wind in the banking sector's sails.

"As long as things are going well, the situation won't get a lot better fast, but it won't worsen," he said. "But any kind of bad news on the horizon would lead to new levels of considerable stress."

He argues against interpreting the lower-than-expected demand on the ECB's auctions this week as a sign that banks are getting back to normal regarding bank-to-bank and commercial lending. He points to the record amounts of cash that banks are parking in the ECB's low-yielding but safe overnight deposit facility.

In an atmosphere of properly functioning markets, the ECB facility is used by banks to park perhaps a few hundred million euros. However, that number has gone into the billions, Jaeger-Ambrozewicz says, which means banks are still unwilling to lend to each other in money markets, preferring to have their own cash on hand.

"They're using the ECB facility as a rainy-day fund," he said.

Stress-test anticipation

In the next indication of banking stability, the results of so-called "stress tests" on banks is expected to be released at the end of this month. The tests are meant to reveal how prepared banks are for possible sharp downturns in the market or other shocks. The goal is to dispel fears about banks' financial health or to determine weak spots and address underlying problems.

Europe's Committee of European Banking Supervisors (CEBS) - a group of the 27-nation bloc's national supervisors - is now testing 25 larger banks and will soon look at a wider group of 100 banks, including German and Spanish regional banks, which have been severely shaken by market volatility and struggled under high debt loads.

"I do not believe that any of the 16 German banks tested could fall under the crucial six percent in terms of the Tier 1 ratio," a senior banking source told Reuters, adding that he also did not believe Germany's regional Landesbanken would fail the test either, although some fear they could be carrying high levels of debt on their books.

Sources told the news agency that the first three banks to be tested in Germany - Deutsche Bank, Commerzbank and the Landesbank Bayern LB - had passed the initial rounds.

If a German bank were to fail, the Bundesbank would ask them to access capital markets or get funds from the rescue fund Soffin, which has already pumped billions into Commerzbank and took over troubled property lender Hypo Real Estate.

Credibility

"The stress tests are good, if they are designed well and take into account sovereign default," Jaeger-Ambrozewicz told Deutsche Welle, referring to debate over whether or not the possibility of a nation like Greece or Spain or other debt-loaded nation defaulting on that debt should be part of the test. "If it's not, the test is not credible."

Finance ministers from the 27 EU countries, who are meeting to discuss the stress tests in two weeks, will ask CEBS to extend them to include a "significant market share of institutions" in each nation, which would include default scenarios. Some fear, however, that this might imply that regulators see debt default as a real possibility, which could further unsettle investors.

"The tests have to present scenarios that are extreme and maybe even unlikely, but not completely nonsensical," Jaeger-Ambrozewicz added. "Greek default, for example, is a possibility that is certainly not nonsensical."

Author: Kyle James
Editor: Andreas Illmer