Stress tests

When the EU-wide bank stress test results were made public in July, skepticism soon followed. After all, just seven of 91 banks failed, leading some to believe the tests had been too easy.

None of Ireland's banks failed. Yet the country floundered under the sheer expense of bailing out and reforming its financial system. In private, the chief financial officer of a European bank recently referred to the stress tests conducted over the past year as nothing more than a "placebo for the market."

Gerhard Hofmann, a board member of the National Association of German Cooperative Banks (BVR), is skeptical about the accuracy of the tests. He isn't aware of any cases in which they "actually had a high level of revelatory value, or a high level of predictive power in regards to future problem areas," he told Deutsche Welle. "What is put under stress today is most likely not tomorrow's problem."

First public results

According to Benjamin Fischer, a spokesman for German financial regulator BaFin, three German banks were subjected to the first European Union-wide stress tests in 2009. Those results were not published. The number then jumped to 15 in 2010, although one bank was the subsidiary of an Italian bank and was tested by that country's financial regulator. The results of these tests were published.

"It was a novelty that the results were made public," Fischer told Deutsche Welle. "Naturally, it made working on the stress tests more difficult because the attention was significantly more present."

Stress tests, according to Fischer, are hypothetical instruments normally used in the banking industry. "Banks and regulators use stress tests as a kind of early-warning system to identify possible weaknesses ahead of time," he said.

Each EU nation carried out a test prescribed by the Committee of European Banking Supervisors (CEBS). While another stress test is likely in 2011, it remains to be seen whether or not results will be made public. A spokesman for CEBS declined to comment.

According to the Central Bank of Ireland, the Irish stress tests were carried out with higher loan loss rates being applied than actually required by CEBS. Still, Ireland's finances buckled and its debt rating plummeted as the country scrambled to save banks teetering on the edge of collapse. Ireland will now receive a bailout from the EU and the International Monetary Fund worth 85 billion euros ($112 billion).

Banks tested at status quo

Michael Schroeder, an economist with the Centre for European Economic Research in Mannheim, said he doesn't believe the Irish crisis invalidates the CEBS stress tests.

"The banks were tested at status quo... and at that point they had already passed on some of their problems to the government," he told Deutsche Welle.

Each individual bank was placed under artificial stress, Schroeder says, but a different picture, he argues, would likely emerge if the pressure were applied system-wide.

"The problem with the financial crisis was that many banks had similar portfolios and reacted similarly – in that they wanted to get rid of their portfolios," he said. "I don't believe the tests depicted the crisis situation with complete accuracy."

Schroeder advocates a method of risk analysis called CoVaR (Conditional Value at Risk), which is capable of simulating "how the portfolio of a bank reacts when there is a shock in all other banks."

In other words, CoVaR can be used to gain insight into chain reactions throughout a financial system. It is gaining support throughout the financial world, according to Schroeder.

In general, he believes, transparency in stress testing is a worthy objective.

"There was a lot of discussion about whether to publicize the results," Schroeder said. "If the information is reliable and accurately represents specific problems then, yes, I would publicize it. Those who are active in the market and deal in stocks and investment on a large scale should know about it."

Market supplanted by European Central Bank

One possible pitfall is that stress testing can backfire if publicized results turn out to be inaccurate. Bankers are currently fretting over whether Ireland and other troubled EU countries will be able to fully repay government bonds. To play it safe, they often turn to the European Central Bank (ECB) to deposit their assets and secure lines of credit.

Fidel Helmer of the Hauck & Aufhauser bank says industry-wide mistrust affects all players. Banks lend less among themselves, and the supply and demand for money is routed over the ECB instead of the open market.

"I think that Deutsche Bank, for instance, is under excellent leadership and will fetch excellent results," he told Deutsche Welle.

Nevertheless, the value of the bank's stock took a nose dive this year. That development is something Helmer directly attributes to the CEBS stress tests. He said the tests were questionable and so far-reaching that they cast doubt even on healthy institutions.

Author: Gerhard Schneibel / Michael Braun
Editor: John Blau