Has the EU’s stress test failed?

Published in Business Spectator (Melbourne), 7 July 2011

As the whole world worried about a potential Greek collapse, another European country experienced two actual bank failures. And no, they did not happen in Portugal, Spain or Italy. In fact, the failures didn’t even occur in the eurozone. The country in question is Denmark.

Remember last year when the European Union’s banking stress test came to the comforting conclusion that, by and large, there were no reasons to be concerned about Europe’s financial system? Whether the methodology behind the Committee of European Banking Supervisors report in July 2010 was correct or overly lenient for the banks was controversial even then.

However, it was often overlooked that the CEBS report only dealt with 91 financial institutions, representing roughly two thirds of the EU’s banking sector. This means that many smaller banks were excluded from it. In Denmark, for example, only the three biggest banks (Danske Bank, Jyske Bank and Sydbank) were tested. The two Danish banks that failed this year, Amagerbanken – which collapsed in February – and Fjordbank Mors – which failed just two weeks ago – were not among them.

This begs the question of whether the much celebrated stress test last year amounted to more than just an exercise in calming the markets. And if it was no more than this, what other risks have been overlooked?

For example, there is the disputed definition of the capital basis of Germany’s Landesbanken, which recently caused tensions between the European Bank Authority and some German state-owned banks.

Last year’s stress test also did not include a scenario in which a member of the eurozone defaults on its debt. That may have appeared unthinkable back then but in light of recent developments it now almost looks like a certainty.

And then, of course, there is the possibility that the euro itself may not survive the sovereign debt crisis. However, the implications of this scenario might be so severe that they are hard to model. For a start, a Greek exit from the euro could derail all Greek banks, not just ATEbank, which did not pass the test last year.

The problems in Denmark’s banking system are still results of the global financial crisis. As in most other countries, the Danish government had initially guaranteed all deposits in national financial institutions. This guarantee expired in September last year, and ever since then Copenhagen has been pursuing a much tougher policy against the country’s financial sector. This means that depositors and other unsecured creditors of distressed banks are no longer fully protected. Bankruptcy and loss of investment is now a real possibility in Denmark’s financial sector.

This is what happened to Amagerbanken, a small bank with a customer base of just over 100,000. After heavy write-downs on some of its investment, the bank’s equity had fallen to just 2.4 billion Danish kroners (approximately $440 million). It was at this stage that the bank had to be closed and taken over by the Danish Financial Stability Company (Finansiel Stabilitet), the government’s financial rescue authority. Only €100,000 (approximately $135,000) per customer were protected, while any remaining investments with Amagerbanken were subject to a substantial haircut of 41.2 per cent. The healthy parts of the bank have since been transferred to its competitor BankNordik.

A similar procedure is now awaiting the customers of Fjordbank Mors. With 73,000 customers it is smaller than Amagerbanken, and again only €100,000 per client is protected. For more than 99 per cent of Fjordbank savers, that is enough to fully compensate them. However, there is no similar protection for shareholders, who are likely to lose their investment. Bondholders are only safe if they had purchased bonds issued before the expiry of the Danish government’s guarantees. Holders of unsecured claims can expect a haircut of 26 per cent, the Danish Financial Stability Company announced.

There are fears the crisis will spread to more financial institutions because the difficulties experienced by Amagerbanken and Fjordbank are not unique. Other Danish banks are equally exposed to non-performing loans, particularly in Denmark’s property and construction industry. But this is not the only problem in the Danish banking sector right now.

Last month, there was a very public spat between rating agency Moody’s Investors Service and Danske Bank’s mortgage subsidiary, Realkredit Danmark. Moody’s had demanded additional capital of €6.2 billion to maintain Realkredit’s AAA rating. Realkredit hit back at Moody’s, claiming the rating agency did not understand the Danish mortgage market and announced it would no longer have its products rated by Moody’s. Whether it’s Realkredit or Moody’s that is right in this case hardly matters, but the dispute underlines suspicions that Denmark’s financial system is perhaps not quite as safe as was hoped.

There are real worries now that Denmark might head for a repeat of the initial stages of the financial crisis, when several of its banks had to seek protection under the umbrella of the Danish Financial Stability Company. The reason then was the bursting of a bubble in Danish residential property. At the time, the collapse of Roskilde bank was shouldered by the entire Danish banking system. In the wake of Roskilde, other Danish banks had to be saved as well.

Last year, when the results of the EU stress test were announced, Denmark’s financial regulators were jubilant. “The Danish Financial Supervisory Authority and Danmarks Nationalbank welcome the EU stress test and find the results for the European banking sector overall positive”, they declared in a joint press release. “The results do not change the perception of financial stability in Denmark, and hence no new initiatives are called for.”

As it turns out now, such celebrations were premature. By just focusing on the three biggest banks, it was forgotten that more risks could hide under the surface. Besides, even the stress test’s own pessimistic assumptions have turned out to err on the side of optimism.

For Denmark, the EU stress test assumed a 1.6 per cent correction in residential property for 2011 in its adverse scenario. But Danish real estate is currently so soft that an even stronger correction for this year is still possible. Reality may be worse than the simulation of the stress test. Needless to say, part of the costs of depositors’ protection for the now bankrupt regional banks has to be borne by Denmark’s bigger banks. But no provision for these extra costs had been made in the stress test.

In hindsight, last year’s stress test only confirmed what everybody already knew at the time: The nationalised German zombie bank HypoRealEstate, a Greek bank and five Spanish cajas did not pass the 6 per cent capital adequacy ratio of Tier 1. But beyond that, the test pretended that everything else was fine. As Denmark now demonstrates, this says more about the design of the stress test than about the real health of Europe’s financial system.

Denmark is a small country, so problems in its financial sector should not cause wider disruptions in Europe’s financial system. Or at least, one would hope not. Nevertheless, it is worrying that the EU’s banking stress test failed to spot the conditions which led to the country’s current problems.

As long the risks of a eurozone member’s default and the collapse of the euro remain excluded from future stress tests, doubts remain about the usefulness of the analysis. And as the Danish example shows, you cannot solve problems by ignoring them.

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