Credibility, the fundamental element that is missing from the European banks' stress tests

At a late hour on the last working day of the month of July 2016, the European Banking Authority will publish the result of the latest stress test applied to the most important financial institutions on the continent.

Unlike other previous "exercises" that were just as useless, the results which will be published on July 29th, at 23 (author's note: Romanian time), they will not include an essential element: the level which the passing of the test is evaluated against.

Ever since the announcement of the new stress test, in February 2016, the EBA has stated that "passing requirements are not included, because the objective of the test is to use it as a supervision instrument, and the results will be discussed individually with the participating banks, where actions for improving the situation will also be proposed".

The methodology for assessing the solvency as part of the stress test is found on the official website of the EBA, www.eba.europa.eu and should at least engender a minimum of faith among investors when it comes to the banks' abilities to deal with non-performing loans and capitalization deficit.

Unfortunately, a general state of "fatigue" seems to have taken place in the Eurozone, amid the waiting in vain for the results promised by the central banks and governments.

According to Reuters, amid the disputes between the European and Italian authorities, concerning the initiation of a new bail-out program for Italian banks, but without the prior application of the bail-in procedure, Mario Draghi, the president of the ECB, has expressed his support for the governmental aid offered to Italian banks, because "such a program will allow them to sell some of their non-performing loans, which reduce their lending ability".

But is such a "release" of Italian banks' lending capability rational and prudent, when the current volume of non-performing loans shows that they are incapable of correctly evaluating risks?

In the recent meeting of finance ministers of the G20 countries, Pier Carlo Padoan, Italy's finance minister said that "we are going in the right direction and there are no risks when it comes to systemic stability", according to an article in Financial Times. Padoan also rejected the possibility of a bail-in, as he said that such a measure would not be necessary.

Shortly after Padoan's statements, shares of the Monte dei Paschi bank saw a new massive drop in Milan, according to Bloomberg, over "concerns over the need for a capital increase". Other information on the web indicates that the Italian authorities already know the results of the stress tests, and that has allowed the finance minister to express his faith in the stability of the banking system in the country.

A completely opposed opinion on the financial stability of the Italian financial system comes from the statements several Italian professors gave Financial Times.

Marcello Messori, a professor at the LUISS University of Rome said that "banks have allocated funds in a distorted and not at all selective manner", while Lorenzo Gai, a finance professor at the University of Florence, estimates that the loan portfolio of the Monte dei Paschi bank represents a "a paradigmatic history of value destruction", as "the management of the loan granting process did not work, and that is an euphemism".

This explains the concerns of the Italian authorities rather well, but 50 billion Euros, the amount of the bail-out program "negotiated" with Brussels, will not be enough.

As if the Italian "surprise" wasn't enough, Financial Times also recently wrote about "the potential major losses of the Portuguese banks", quoting an estimate of Barclays analysts, of 7.5 billion Euros, the amount needed for "resolving a systemic banking crisis". "Portuguese banks, already undercapitalized and full of non-performing loans, are preparing for massive losses as a result of the failed attempts of the Lisbon authorities to sell Novo Banco", the FT article states. Novo Banco is "the good bank" resulting from the massive intervention of the state to "save" the Espirito Santo bank two years ago, and its "recapitalization" was made at the end of last year through a concealed bail-out of the creditors, through transferring the bonds to the "bad bank".

As can be noticed, Europe has reached the point where establishing the difference between a bad bank and a good bank represents an impossible task, but even so , the authorities are trying to launch a new smokescreen with the help of the "stress tests".

The exercise is useless because it lacks a fundamental element: credibility. In a recent article on Bloomberg, called "The failure of Europe's stress tests", Mark Whitehouse writes that "the tests won't go far enough to show the various vulnerabilities of banks", because "the authorities lack the motivation to be tough".

Why do the authorities not want to know the truth, but even more, for it not to be known? Because "the new rules of the banking union limit the possibilities of recapitalizing weak banks", and a significant number of banks failing the test would start a panic, instead of "catalyzing the much sought after healing process", according to the Bloomberg editorialist.

An alternative stress test presented by Whitehouse is the one made by the Center for Risk Management at Lausanne (CRML) of the University of Lausanne (found at www.crml.ch). The latest estimates, at the end of last month, show that the capital deficit for about 110 financial and insurance institutions in Europe amounts to 1.2 trillion Euros. The "stress" test taken into consideration by the CRML is a financial crisis characterized by a 40% drop of the global stock exchanges within six months.

Compared to the verdict by professor Kevin Dowd, of the University of Durham of Great Britain, what the Bloomberg editorialist writes is almost "a praise". In an article published in Cato Journal (author's note "Central Bank Stress Tests: Mad, Bad, and Dangerous", vol. 35, nr. 3), professor Dowd shows that "the banking stress tests are foolish and insane", because they rely on "financial risk models, which are not just useless, but even worse than useless".

Even so, these models are the last lifeline for a banking system which the authorities are having increasing difficulty in protecting from the assault of reality, because "avoiding the truth has consequences", Mark Whitehouse further writes, referring to how the "European authorities have ignored the banks' weaknesses over the last seven years".

It is precisely the victory of reality over the risk models or the dreams of global domination that has caused the acceleration of the process for the exit of some major institutions from the fringe markets, especially from the emerging economies.

"Banks are starting to realize that offering all products and services to all customers in every country was a mistake", Vikram Pandit, CEO of Citigroup between 2007 and 2012, told Bloomberg.

Under these circumstances, "banks are selling assets and leaving markets and we are far from the end of the process", Pandit further said, whose opinions were published in an article concerning the massive withdrawal of Citigroup and of the HSBC conglomerate from the international markets.

The major European banks will see a similar trend, whose recapitalization options through new shareholder contributions are extremely limited.

All that is left is the massive sale of assets, and financial institutions rushing in that direction will have the most to gain, contributing to the fragmentation until the disappearance of the dream of the banking union.