by Anil Kashyap, Kermit Schoenholtz and Hyun Song Shin
Wall Street Journal
March 23, 2011
Europe seems determined to repeat its mistake and undertake a second round of ineffectual stress tests on its banks. The 2010 version did little to alleviate banks' spiraling funding costs or to restore confidence in European markets. Unless the design of this year's tests is fundamentally different from last year's, Europe's crisis will persist.
Insufficient capital, combined with volatile financing, makes the European banking system prone to a run. Unlike banks that rely on retail deposits only, banks that depend on short-term borrowing from financial intermediaries or large corporations in competitive money markets must meet a much higher standard of solvency to prevent runs. When bank equity falls short of this "run point," getting money from private markets becomes difficult. In Europe, some banks have turned increasingly to borrowing from the European Central Bank, while paying higher premiums to borrow in private markets to compensate for their risk of default. The results from our research with Morgan Stanley's David Greenlaw, commissioned by the University of Chicago Booth School of Business's Initiative on Global Markets, suggest that two things must occur to end the lingering financial crisis in Europe.
First, private lenders must be confident that there is a ceiling on European banks' potential losses. A competent stress test could provide this information. To be credible, the test would have to anticipate likely bank losses in truly adverse conditions. Because European banks own large amounts of sovereign debt issued by countries that might not be able to pay in full, the possibility of a government-debt restructuring must be considered in the stress scenario. Realistic growth prospects and losses on housing loans also must be examined. That the Bank of Spain and Moody's differ by roughly €100 billion on their worst-case scenarios for Spanish banks' capital shortfalls (below existing requirements) demonstrates how far European authorities will need to go to be credible in this respect.
The second necessary ingredient is a credible plan to recapitalize Europe's banks that are found to have inadequate capital to forestall runs. Pronouncements of solvency are not enough. European policy makers would do well to remember that creditors' 2010 run on Irish banks came after these institutions received clean bills of health in last year's stress test.
The research on which this op-ed is based can be found here.