Beware an overly rosy interpretation of last month's EU-wide bank stress tests. They used unreliable measures of bank capital ratios. The ECB must do more to fix undercapitalisation

On October 26th 2014 the European Central Bank (ECB) and the European Banking Authority (EBA) released the results of the latest EU-wide stress test and the accompanying asset quality review (AQR).

The 2014 stress test encompasses four key findings:

• The aggregate capital shortfall for the 123 banks participating in the test is €24.6 billion;
• Only 24 of the 123 banks are undercapitalised, as indicated by their inability to meet transitional common equity tier one capital ratios of 5.5 and 8.0% in the baseline and adverse scenarios, respectively;
• The undercapitalised banks are all in Italy, Greece, and Cyprus; and
• The largest banks in France and Germany have ample capital.

These conclusions are simply not credible. To understand why, consider the following facts and arguments.

• Over the past five years, a solid body of empirical work has shown that bank capital ratios employing unweighted total assets in the denominator – so-called leverage ratios – are far more effective in distinguishing sick from healthy banks than risk-based measures that use risk-weighted assets in the denominator. The 2014 test (like its three predecessors) used only a risk-based measure of bank capital. This is not technical hair-splitting but rather an issue that cuts to the very heart of the credibility of stress tests.
• In the run-up to the global financial crisis of 2007-2009, risk-based capital measures were indicating that the largest US and EU banks were well-capitalised; by contrast, leverage ratios were indicating that these banks had thin capital cushions. Since many of these banks wound up needing official support during the crisis, it is clear which metrics were sending good signals and which were not.
• During the 2011 EU-wide stress test (the last one conducted before the 2014 test), the bank deemed the safest by its very high risk-based ratio, Irish Life and Permanent, had to be placed in a government restructuring programme in 2012. Dexia (a French-Belgian bank) and Bankia (based in Spain) also passed the 2011 test, only to require rescue at taxpayer expense a short time after. A revealing study by two European economists showed that if a 3% leverage ratio had been used as the hurdle rate in the 2011 test, 26 banks would have failed instead of three. Among the failures would have been some large German and French banks, including Deutsche Bank, Commerzbank, BNP Paribas, and Société Générale. A 4.5 leverage ratio would have caught all the banks that subsequently failed. No value of the risk-based measure would have done so while still allowing some banks to pass the test.
• Beware of claims by executives from the largest French, German, and Dutch banks emphasizing the credibility of the 2014 stress test results and belittling the results of stress tests done by outside analysts using alternative metrics, including leverage ratios. They may well just be talking their book. Because large French, German, and Dutch banks have low leverage ratios and low ratios of risk-weighted assets to total assets, they invariably look better under a test that uses risk-based measures rather than leverage ratios. Indeed, Martin Wolf shows that the gap between leverage ratios and the risk-based capital metric used in the 2014 test is wider for Dutch, French, and German banks at the ‘centre’ of the euro area than it is for Greek, Portuguese, Irish, Italian, and Spanish banks on the ‘periphery’.⁶
• Ever since Christine Lagarde, the IMF’s managing director, put a spotlight in August 2011 on the need for ‘urgent capitalisation’ of Europe’s banks, a host of estimates by independent analysts has suggested a significant undercapitalisation of Europe’s banks. Quite a few of these studies use leverage ratio benchmarks – sometimes supplemented with measures of systemic risk – to gauge the extent of undercapitalisation. One, for example, continues to find an EU-wide capital shortfall of hundreds of billions of euros – a far cry from the €25 billion EU-wide shortfall arrived at in the 2014 stress test. Moreover, the largest part of that aggregate shortfall resides with large French banks.
• The US Federal Reserve has been employing a leverage ratio test in its annual stress tests since 2012. The Bank of England announced that it likewise plans to do so in its own stress tests, due later this year. In discussing the heralded resilience of Canadian banks during the 2007-2009 crisis, Mark Carney has testified that ‘if I had to pick one reason why Canadian banks fared as well as they did, it was because we had a leverage ratio.’
• Last but not least, two popular defences of the existing level of capitalisation in EU banks should be discarded.
• The first claims that large EU banks are adequately capitalised if they have approximately the same capital ratios as large US banks. This contention overlooks the ‘too-big-to-fail’ problem, which is more severe in the European Union than in the United States. EU bank concentration – if properly measured at both the individual-country and EU-wide levels – is higher than in the United States. In addition, bank credit accounts for a higher share of total financial intermediation in Europe. Large EU banks should therefore be holding more capital than their US counterparts – not less, as recent data on leverage ratios indicate.
• The second defence suggests that large EU banks have enough capital if their capital ratios are similar to those of their global peers, broadly defined. But bank capital ratios are almost surely too low everywhere. Drawing on both theory and empirical evidence, Admati and Helwig (2013) make a persuasive case for higher bank capital requirements. In a similar vein, 20 distinguished professors of finance (including two Nobel laureates) concluded (in a November 2010 letter to the Financial Times) that bank leverage ratios ought to be about 15% and that achieving such a target would generate substantial social benefits, with minimal if any social cost. This target is far from the 3% minimum for the leverage ratio established under Basel III and far from actual leverage ratios maintained by large banks around the world. All of this suggests that the capital hurdle rates used in the 2014 EU-wide stress test are more likely to be too easy (low) than too tough (high).

On the eve of becoming the Single Supervisor for Europe’s largest banks, the ECB missed an important opportunity to establish trust in EU bank supervision. By refusing to include a rigorous leverage ratio test, by allowing banks to artificially inflate bank capital, by engaging in wholesale monkey business with tax deferred assets, and also by ruling out a deflation scenario, the ECB produced estimates of the aggregate capital shortfall and a country pattern of bank failures that are not believable. This was not a case of ‘doing whatever it takes’ to establish credibility, but rather one of avoiding the tough decisions and asking the market to ‘take whatever’. When it comes to fixing the long-running undercapitalisation of Europe’s banking system, what European authorities have delivered will not be enough.

Morris Goldstein is a senior fellow at the Peterson Institute for International Economics. This post first appeared in full on the Vox website