Money Morning Mailbag: Jaded Investors Cast Wary Eye On Scope of Bank Stress Tests

The results of Europe's bank stress tests are due July 23. But the question remains whether the tests will shed enough light on the banking sector to restore investor confidence.

"All these stress tests mean that we are peeling away layers of the onions, but chances are we are not going to get the full clarity that we as investors deserve," Neil Dwane, chief investment officer for Europe at equities specialist firm RCM, told The New York Times.

Readers who are already on guard from Wall Street manipulation and stalled financial reform have pulled back from volatile markets and are skeptical about the effectiveness of bank stress tests:

I am currently out of the market and may never return simply because I feel I'm being "played" by "Big Money," big banks, etc. like a pawn in a chess game.

My faith in the system is all but gone. Governments will print more money and we all know that eventually ends. We now have countries that are broke like Greece, Italy, etc.

Lastly, can we really believe that the European banks are going to tell the whole truth about the stress tests? Just more smoke and mirrors.

- J.D.

The goal of the Committee of European Banking Supervisors (CEBS), which is coordinating the tests, is to determine which banks need to raise more capital to withstand a variety of damaging economic conditions. The European Union (EU) already widened the tests' scope under investor pressure to increase transparency to include more banks and test for protection against a sovereign debt crisis stemming from Greece.

The tests now include 91 banks and will include a "sovereign risk shock element" by projecting haircuts of 40% on the value of Greek bonds.

But the tests still hold many unknowns, like the scale of haircut on Spanish and other debt-laden nations' bonds, what the required capital ratio will be, and how long banks will have to raise funds.

While the EU feels any problems found in the tests will be easy to solve, European leaders cannot agree on how much of the results should be published. Policymakers' reluctance to share doesn't do much to bolster confidence in investors, who are already wary of what may be hiding on banks' balance sheets.

While France has questioned the need to publish banks' exposure to sovereign debt, Germany supported publishing the exposure and Britain and Spain pushed for full transparency.

"There is still too much turmoil on the markets, partly because there are still uncertainties over the banks...so that is why transparency is better," German Finance Minister Wolfgang Schaeuble told reporters.

Compared to the U.S. bank stress tests conducted last year, analysts say Europe's version falls short. The U.S. tests led to a climb in bank share prices.

U.S. officials released a white paper last year, two weeks prior to the tests results report, describing the methodology and assumptions the tests would use. Europe has not followed suit - something that would ease the minds of both investors and analysts.

Another lesson learned from U.S. testing was that assets not included on balance sheets could come back to bite the bank later. It is unclear if Europe's tests will cover the full scope of banks' holdings.

Analysts also think European banks could be holding a smaller ratio of tangible common equity (TCE), the amount of losses a bank can handle before shareholder equity is wiped out. A recent analysis by Deutsche Bank of over 42 large European banks showed the average TCE was 3.2%. When U.S. banks were "stress-tested" last year they had an average TCE ratio of 6.9%.

If the Basel Committee on Banking Supervision, which is due to release capital requirements later this year, raises its TCE requirement to 6%-8% as some analysts expect it to, European banks would need to raise about $758 billion - $1.26 trillion in tangible equity to comply.

If Europe's bank stress tests fail to show a banking sector that's able to withstand financial meltdowns, investors will want to follow our reader's route and take their money out.

"The consequences could be severe in terms of liquidity hoarding and further breakdown of bank funding markets," Credit Suisse analysts wrote in a report.

Outside the European Union, one country isn't delaying any longer in strengthening its banking sector.

Swiss regulators announced Wednesday that they would implement stricter banking rules in January 2011 to raise bank's capital. Although the Basel Committee has delayed announcing new capital requirements, the Swiss banking regulator FINMA has already started consulting to adjust its rules based on the committee's proposals.

The Basel Committee might also add a leverage ratio test to its banking requirements, which Switzerland already uses. Leverage ratio tests are calculated with full balance sheet assets instead of risk-adjusted assets. Countries that don't conduct leverage tests don't expose a clear picture of the value of banks' holdings during times of stress.

Investors losing faith in the financial industry - regardless of a country's efforts to reform - but who don't want to miss out on the market altogether should engage in defensive investing. Money Morning's "Defensive Investing" series examines the best ways to deal with market volatility, how to protect against inflation, and how to choose the right dividend stocks and mutual funds.

(**) Money Morning editors reserve the right to edit responses for grammar, length and clarity when posting on our Web site. Please include your name and hometown with your email.

News and Related Story Links: