Les Marioles de la BCE, leurs tests et les banques

Financial Times: Alternative stress tests find French banks are weakest in Europe

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On Sunday, Christian Noyer, governor of the Banque de France, was crowing about the “excellent” performance of French banks on the European stress tests

Many of their Italian and Greek counterparts might have flunked but France could be proud of its banking sector. “The French banks are in the best positions in the eurozone,” said Mr Noyer.

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Not so fast.

Two days earlier, a different test found that the French financial sector was the weakest in Europe.
The team with the temerity to deliver this bucket of cold water to Paris works at the wonderfully named Volatility Institute at New York University’s Stern school and presented its findings from a safe distance – a financial conference at the University of Michigan.

The chief architect, Viral Acharya, has worked on systemic risk ever since the last crisis, attempting to design a bank safety test that can be run all the time – not at the whim of regulators.

Using his methodology, which he calls SRISK, Mr Acharya found that in a crisis French financial institutions would have a capital shortfall of almost $400bn, worse than the US and UK despite their much bigger financial sectors. Looking just at the French banks tested in the ECB stress tests, which found zero capital shortfall, SRISK came up with €189bn.

Mr Acharya did not have access to the 6,000 officials who scoured balance sheets across Europe to gauge the health of the continent’s banks.

But his results, which have implications for other countries, including China, should not be ignored.

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Take Société Générale. France’s second-biggest bank by market value did fine on the ECB’s stress test. But on Mr Acharya’s measure, the bank has a large capital shortfall in a crisis.

There are a couple of big reasons for the difference. First, SRISK takes into account the banks’ total balance sheet without regard for risk: unlike the ECB, it does not attempt to distinguish between €1m of German Bunds and a €1m loan to a dipsomaniac farmer with a rusty tractor.

Second, it does not care what banks’ book value of equity is; it uses what the stock market says it is. Under the ECB’s methodology, SocGen has €36.6bn of equity today and, in a crisis, would have €30.7bn of equity against €377bn of risk-weighted assets. That equates to a passable 8.1 per cent capital ratio even in a deep recession.

According to Mr Acharya’s methodology, the bank has only €30bn of market equity today against €1,322bn of assets for a much weaker capital ratio of 2.3 per cent. In a crisis, when market values would plunge further, SocGen would be left with a shortfall of more than €60bn.*

Using the stock market to compute a bank’s equity makes SRISK vulnerable to irrational optimism or irrational pessimism of investors. But Mr Acharya finds three good reasons to use it. “Markets told us that subprime MBS [mortgage-backed securities] had become poor in quality and liquidity; book values and regulatory risk weights did not,” he says. “Market values are also harder to manipulate by management through understatement of losses or provisions. Finally, banking crises are caused by drying up of credit by financiers. Financiers are not interested in book values or regulatory capital per se, but whether the firm can raise capital if needed to repay them. This is best captured by market value.”

It is not just France’s regulators and banks that might be well-advised to stop patting themselves on the back and consider other measures of systemic risk. Europe’s aggregate SRISK has fallen since 2011, with the deleveraging of balance sheets following the eurozone crisis. Systemic risk in the US has also fallen by half since 2008. But risk in China has picked up significantly and now surpasses the US. If anything, Mr Acharya notes, the problem is likely to be understated because of the amounts of off-balance sheet debt in China. In the US, JPMorgan Chase’s leverage might be much better than its French counterparts, but its SRISK is bigger: a $98.4bn shortfall in a crisis. MetLife, which is considering suing the US government over its designation as a systemically important company, is found to pose a bigger systemic risk than Goldman Sachs.

If you believe that financial companies always appropriately value their assets and never try to massage the value of their equity and if you believe that officials are always diligent in examining banks’ accounting then SRISK is a waste of time. But if you believe this you haven’t been paying attention for the last decade.

http://www.ft.com/intl/cms/s/0/fad2c772-5dd7-11e4-b7a2-00144feabdc0.html#axzz3HKu5YEuZ