Italian Bankers are Not Amused

Italy’s banks were among the hardest hit by the ECB’s “comprehensive assessment” and the associated demands to increase their capital. The protests of Italian banks which were even echoed by the Bank of Italy (i.e., Italy’s national central bank) are widely seen as a lending the stress tests legitimacy.

For instance, the FT reports:




“Analysts and investors have taken the howls of protest from Italian central bank officials on Sunday as evidence that the European Central Bank’s health check on the continent’s banking system is sufficiently tough.

Complaints from Rome about the outcome of the ECB’s comprehensive assessment have demonstrated how Italy has emerged as the biggest loser from the process, which was designed to restore confidence in the EU’s financial system.”


“The debate over whether the European banks have lots of holes in their balance sheets is over,” said Davide Serra, founder of hedge fund Algebris. “Banks didn’t know if they had enough capital to lend until now and this will change that.”

“We now know that we can have a 5 per cent contraction in the eurozone economy and the banks will still have more than 8 per cent capital – that is very positive for the sector,” he said.


Alas, as this Bloomberg video shows, the debate is far from “over” – not least as numerous banks just sort of scraped by.

In fact, there are other reasons to doubt the toughness of the stress test. We already discussed the large amount of legacy NPLs in the European banking system yesterday, which implies that if a severe downturn were to occur in the near future, this amount would skyrocket to an even more astronomical level.

Moreover, a post stress test aggregate capital shortfall of a mere € 24 billion is just not very believable considering all the other data, especially in light of the fact that the great bulk of this shortfall is concentrated in the tiny countries of Cyprus and Greece.


How Adverse is the “Adverse Scenario”?

Let us briefly consider the scenario the ECB employed. How “stressful” is it really? Banks merely had to deal with a doubling of the current extremely low levels of interest rates for instance. What if sovereign interest rates were to skyrocket again as they did in 2009-2011? Note that this time, the books of banks in the largest peripheral countries are laden with more than twice as much sovereign debt than in late 2011 – which is partly a result of misguided regulatory incentives.


1-ShortfallMost of the capital shortfall identified by the ECB is concentrated in Cyprus and Greece. Italy’s shortfall is large in EUR terms, but is actually tiny compared to Italy’s bank assets in toto – click to enlarge.


The ECB’s “adverse scenario” was defined as follows:


“On average in the euro area, the adverse scenario leads to deviation of euro area GDP from its baseline level by -1.9% in 2014, -5.1% in 2015, and -6.6% in 2016. The euro area unemployment is higher than its baseline level, by 0.3 percentage points in 2014, by 1.2 percentage points in 2015, and by 2.2 percentage points in 2016. For most advanced non-euro area economies, including Japan, the UK and the US, the scenario results in a negative response of GDP ranging between 5% and 7% in cumulative terms compared to the baseline.

Furthermore, while the adverse scenario does not strictly embody a prolonged deflationary environment, it does entail material downward pressures on inflation. Thus, the scenario leads to annual inflation rates for the euro area below the baseline rates by 0.1 percentage points in 2014, by 0.6 percentage points in 2015, and by 1.3 percentage points in 2016. The implied adverse inflation rates amount to 1.0% in 2014, 0.6% in 2015 and 0.3% in 2016.”


Note that the baseline scenario is “founded on the European Commission’s Winter 2014 forecast” and the above is merely the deviation from this baseline scenario – i.e., the contraction of GDP in the “adverse” scenario does not amount to 5 percentage points as Mr. Serra apparently believes, but only somewhere between 2% and 3%. Similarly, peak unemployment would only amount to some 13% in this scenario – not far above the actual euro area-wide unemployment rates that have recently been seen.

A repeat of the sovereign debt crisis has been completely excluded from the deliberations, and a number of ancillary risks were also not considered (ranging from “hard to value level 3 assets” to “provisions for litigation risk”).

There can be no doubt the ECB’s stress test exercise was tougher than the tests previously conducted by the EBA. However, the more we are looking at the details, the less convinced we are that the scenario tested was really adverse enough. Especially the fact that a repeat of the sovereign debt crisis is excluded strikes us as a sign of unwarranted optimism (the risk-weighting of sovereign debt remains at zero from a regulatory perspective, which is quite astonishing considering e.g. the recent volatility in Greek government bonds).

As an aside to this it should also be mentioned that although TARGET-2 imbalances have retreated from their peak, almost two thirds of the German Bundesbank’s balance sheet continue to consist of TARGET-2 claims on the euro-system. What if a weak member like Greece does after all exit the currency union down the road? Claims on Greece would probably have to be written off in that case.


2-Greece 10-Year Bond Yield(Daily)Recent volatility in Greek government bonds is testament to the fact that the country’s government is far from being out of the woods. Its solvency continues to be doubted by the markets, and rightly so – click to enlarge.


Even under the conditions of this not overly harsh adverse scenario, the potential capital losses identified by the ECB would be quite large as the next chart shows – France would be hit the hardest (the assets of French banks amount to more than 400% the country’s GDP – the largest three banks alone hold assets amounting to approx. 280% of GDP). Interestingly, Italy’s banks would also suffer slightly bigger losses than Germany’s (and obviously would be somewhat less well prepared to deal with them):


3-capital impactImpact of adverse stress test scenario on bank capital in EUR bn. – France would be hit the hardest, followed by Italy – click to enlarge.



A number of people have been convinced by the ECB’s review and it was no doubt superior to previous exercises of this sort. However, the more closely one looks at the data, the less convincing it all becomes. There is no telling what precise shape the next crisis will take, but by once again attempting to pump up the money supply with “QE”, the ECB is already busy laying the foundations of the next bust. Moreover, since the US economy has been subjected to massive liquidity injections by the Fed, and the BoJ is likewise engaged in a major monetary pumping exercise (even though it is not as effective in actually increasing the money supply), a major bust could well begin elsewhere and take the already weak euro area economy with it.

These policies always have the same result. They distort relative prices, which leads to a falsification of economic calculation and consequently to capital misallocation. For a while, asset prices are boosted and the false economic activities engendered by monetary pumping register as “growth” in aggregate economic statistics, but they will inevitably be unmasked as having destroyed rather than created wealth when policy is normalized again. The “adverse scenario” that develops in the course of the next bust could very easily turn out to be a lot worse than the ECB has envisaged in its review.



Charts by: ECB,




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