Will Bank Stress Tests Lead To Bank Runs?

From: The Wall Street Journal

Tension Builds Over Stress Tests


How stressful will Europe's bank stress tests prove? Investors won't have long to find out. The Committee of European Banking Supervisors, which is coordinating the tests, will on Wednesday publish details of which banks are being tested and what criteria will be used for the exercise.

Regulators are aware of the risks that insufficiently rigorous tests will inflame the volatile market situation rather than ease it. Even so, the tests are likely to disappoint investors in two key respects.

First, the tests will incorporate the risk of a sovereign debt default, but are likely to measure only first order effects, rather than the potentially more damaging second and third order effects. Reports that the stress criteria will include an across the board 3% haircut on all holdings of European government bonds, if true, will be disappointing, given the varying concentrations of government debt holdings across the system.

But although the market has been concerned for months about sovereign bond exposures, the threat is not just the immediate impact on bank capital of a default by a peripheral European country—something ratings agency Moody's recently concluded for the largest European Union banks was likely to be manageable. The bigger threat is the knock-on effects on other asset prices, credit spreads and the macroeconomic environment. Those could be extremely stressful but are unlikely to be adequately tested.

Second, the tests will be based on existing Basel 2 definitions of capital, according to someone familiar with the process.


We have been concerned about European banks in particular for some time now on this blog. While many American banks are weak, European banks operate with extreme leverage - some at 40 to 1 capital ratios. In a deleveraging, deflationary environment where assets values tend to fall - real estate assets and their associated mortgages in particular look vulnerable, a 2 or 3% drop in capital is quite likely. This leads to insolvency concerns once again in the banks.

We should keep a sharp eye on LIBOR during this period. While not much may come of Wednesday's announcement, we could see LIBOR start to climb in anticipation of the test results down the road.

Another area to watch is where deposits flow. As we saw in Greece a few weeks ago, once depositors start to worry, they may send their money elsewhere to perceived safety. A silent bank run may begin.

Quite a long way down the road, we may see bank holidays, if my hypothesis is true. Which is why I cling to gold, the money that owes no one.