More Transparent Bank Stress Tests Are Needed

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More Transparent Bank Stress Tests Are Needed

New York Times – Europe and the United States both need to conduct another round of stress tests on their banks, with a model similar to what was done in the United States in 2009, but with a more negative downside scenario — in particular, assessing the effects of a major sovereign debt problem in the euro zone.

The point of such a scenario is to determine how much equity financing banks need to have if the world economy turns ugly. If the big banks raise more capital in advance, we are less likely to see economic downturn again become financial catastrophe.

The prevailing wisdom about Europe is that it faces primarily liquidity problems. In this view, a few of the larger countries have had trouble rolling over their debts, and some leading banks need help with short-term financing. The European Central Bank can assist with both by buying government bonds and lending to banks and, in the most optimistic interpretation, the consequent political discussions will help strengthen European Union integration.

There are two problems with this positive spin on recent events. The first is that sovereign debt problems can easily become solvency issues — that is, more about whether countries can afford to service their debts rather than whether they can raise enough cash at reasonable rates in any given week. The key issue is growth — if Italy, Spain and others can show they will grow reasonably quickly, then debt relative to gross domestic product will decline, and rosy projections will be back in fashion.

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