In the aftermath of the credit crunch and the recession, many banks had to be bailed out by central banks and some, such as Northern Rock and RBS, were wholly or partially nationalised. Tougher regulations to ensure greater liquidity and higher proportions of capital to total liabilities have been put in place and further regulation is being planned in many countries.
So are banks now able to withstand future shocks?
In recent months, new threats to banks have emerged. The first is the prospect of a double-dip recession as many countries tighten fiscal policy in order to claw down debts and as consumer and business confidence falls. The second is the concern about banks’ exposure to sovereign debt: i.e. their holding of government bonds and other securities. If there is a risk that countries might default on their debts, then banks would suffer and confidence in the banking system could plummet, triggering a further banking crisis. With worries that countries such as Greece, Spain, Portugal, Italy and Ireland might have problems in servicing their debt, and with the downgrading of these countries by rating agencies, this second problem has become more acute for banks with large exposure to the debt of these and similar countries.
To help get a measure of the extent of the problem and, hopefully, to reassure markets, the Committee of European Banking Supervisors (CEBS) has been conducting ‘stress tests’ on European banks. On 24 July, it published its findings. The following articles look at these tests and the findings and assess whether the tests were rigorous enough.
Bank balance: EU stress tests explained Financial Times, Patrick Jenkins, Emily Cadman and Steve Bernard (13/7/10)
Seven EU banks fail stress test healthchecks BBC News, Robert Peston (23/7/10)
Interactive: EU stress test results by bank Financial Times, Emily Cadman, Steve Bernard, Johanna Kassel and Patrick Jenkin (23/7/10)
Q&A: What are the European bank stress tests for? BBC News (23/7/10)
Europe’s Stress-Free Stress Test Fails to Make the Grade Der Spiegel (26/7/10)
A test cynically calibrated to fix the result Financial Times, Wolfgang Münchau (25/7/10)
Europe confronts banking gremlins Financial Times (23/7/10)
Leading article: Stressful times continue Independent (26/7/10)
Europe’s banking check-up Aljazeera, Samah El-Shahat (26/7/10)
Finance: Stressed but blessed Financial Times, Patrick Jenkins (25/7/10)
Were stress test rigorous enough? BBC Today Programme, Ben Shore (24/7/10)
Banks’ stress test ‘very wooly’ BBC Today Programme, Peter Hahn and Graham Turner(24/7/10)
Stress test whitewash of European banks World Socialist Web Site, Stefan Steinberg (26/7/10)
Stress tests: Not many dead BBC News blogs: Peston’s Picks, Robert Peston (23/7/10)
Not much stress, not much test Reuters, Laurence Copeland (23/7/10)
Stress-testing Europe’s banks won’t stave off a deflationary vortex Telegraph, Ambrose Evans-Pritchard (18/7/10)
European banking shares rise after stress tests BBC News (26/7/10)
Euro banks pass test, gold falls CommodityOnline, Geena Paul (26/7/10)
2010 EU-wide Stress Testing: portal page to documents CEBS
- Explain what is meant by a bank stress test?
- What particular scenarios were tested for in the European bank stress tests?
- Assess whether the tests were appropriate? Were they too easy to pass?
- What effect did the results of the stress tests have on gold prices? Explain why (see final article above).
- What stresses are banks likely to face in the coming months? If they run into difficulties as a result, what would be the likely reaction of central banks? Would there be a moral hazard here? Explain.
In the past few days, the euro has been under immense speculative pressure. The trigger for this has been the growing concern about whether Greece would be able to force through austerity measures and cut its huge deficit and debt. Also there has been the concern that much of Greece’s debt is in the form of relatively short-term bonds, many of which are coming up for maturity and thus have to be replaced by new bonds. For example, on 19 May, Greece needs to repay €8.5 billion of maturing bonds. But with Greek bonds having been given a ‘junk’ status by one of the three global rating agencies, Standard and Poor’s, Greece would find it difficult to raise the finance and would have to pay very high interest on bonds it did manage to sell – all of which would compound the problem of the deficit.
Also there have been deep concerns about a possible domino effect. If Greece’s debt is perceived to be unsustainable at 13.5% of GDP (in 2009), then speculators are likely to turn their attention to other countries in the eurozone with large deficits: countries such as Portugal (9.4%), Ireland (14.3%) and Spain (11.2%). With such worries, people were asking whether the euro would survive without massive international support, both from within and outside the eurozone. At the beginning of 2010, the euro was trading at $1.444. By 7 May, it was trading at $1.265, a depreciation of 12.4% (see the Bank of England’s Statistical Interactive Database – interest & exchange rates data
If the euro were in trouble, then shock waves would go around the world. Worries about such contagion have already been seen in plummeting stock markets. Between 16 April and 7 May, the FTSE100 index in London fell from 5834 to 5045 (a fall of 13.5%). In New York, the Dow Jones index fell by 8.6% over the same period and in Tokyo, the Nikkei fell by 7.6%. By 5 May, these declines were gathering pace as worries mounted.
Crisis talks took place over the weekend of the 8/9 May between European finance ministers and, to the surprise of many, a major package of measures was announced. This involves setting aside €750bn to support the eurozone. The package had two major elements: (a) €60bn from EU funds (to which all 27 EU countries contribute) to be used for loans to eurozone countries in trouble; (b) a European Financial Stabilisation Mechanism (a ‘Special Purpose Vehicle (SPV)’), which would be funded partly by eurozone countries which would provide €440bn and partly by the IMF which would provide a further €250bn. The SPV would be used to give loans or loan guarantees to eurozone countries, such as Greece, which were having difficulty in raising finance because of worries by investors. The effect would also be to support the euro through a return of confidence in the single currency.
In addition to these measures, the European Central Bank announced that it would embark on a ‘Securities Markets Programme’ involving the purchase of government bonds issued by eurozone countries in difficulties. According to the ECB, it would be used to:
.. conduct interventions in the euro area public and private debt securities markets to ensure depth and liquidity in those market segments which are dysfunctional. The objective of this programme is to address the malfunctioning of securities markets and restore an appropriate monetary policy transmission mechanism.
Does this amount to quantitative easing, as conducted by the US Federal Reserve Bank and the Bank of England? The intention is that it would not do so, as the ECB would remove liquidity from other areas of the market to balance the increased liquidity provided to countries in difficulties. This would be achived by selling securities of stronger eurozone countries, such as Germany and France.
In order to sterilise the impact of the above interventions, specific operations will be conducted to re-absorb the liquidity injected through the Securities Markets Programme. This will ensure that the monetary policy stance will not be affected.
So will the measures solve the problems? Or are they merely a means of buying time while the much tougher problem is addressed: that of getting deficits down?
Webcasts and podcasts
Rescue plan bolsters the euro BBC News, Gavin Hewitt (10/5/10)
The EU rescue plan explained Financial Times, Chris Giles, Emily Cadman, Helen Warrell and Steve Bernard (10/5/10)
Peston: ‘Crisis is not over’ BBC Today Programme (10/5/10)
Greece ‘will get into even more deep water’ BBC Today Programme (11/5/10)
EU ministers offer 750bn-euro plan to support currency (including video) BBC News (10/5/10)
EU sets up crisis fund to protect euro from market ‘wolves’ Independent, Vanessa Mock (10/5/10)
Euro strikes back with biggest gamble in its 11-year history Guardian, Ian Traynor (10/5/10)
Debt crisis: £645bn rescue package for euro reassures markets … for now Guardian, Ian Traynor (10/5/10)
The E.U.’s $950 Billion Rescue: Just the Beginning Time, Leo Cendrowicz (10/5/10)
Eurozone bail-out (portal) Financial Times
Bailout does not address Europe’s deep-rooted woes: Experts moneycontrol.com (11/5/10)
An ever-closer Union? BBC News blogs: Stephanomics, Stephanie Flanders (10/5/10)
Eurozone crisis is ‘postponed’ BBC News blogs: Peston’s Picks, Robert Peston (10/5/10)
Multi-billion euro rescue buys time but no solution BBC News, Lucy Hooker (11/5/10)
No going back The Economist (13/5/10)
It is not Greece that worries EURO: It is China that teeters on a collapse Investing Contrarian, Shaily (11/5/10)
Data and official sources
For deficit and debt data see sections 16.3 and 18.1 in:
Ameco Online European Commision, Economic and Financial Affairs DG
For the ECB statement see:
10 May 2010 – ECB decides on measures to address severe tensions in financial markets ECB Press Release
- Why should the measures announced by the European finance ministers help to support the euro in the short term?
- Why should the ECB’s Securities Markets Programme not result in quantitative easing?
- Explain what is meant by sterlisation in the context of open market operations.
- What will determine whether the measures are a long-term success?
- Explain why there may be a moral hazard in coming to the rescue of ailing economies in the eurozone. How might such a moral hazard be minimised?
- Why should concerns about Greece lead to stock market declines around the world?
- What is the significance of China in the current context?
A key determinant of the credit crunch was a shortage of liquidity and a breakdown of the interbank lending market. In an attempt to ease the credit situation and restart the interbank lending market, the Bank of England auctioned over £40bn of credit at the end of September. The aim of this was to boost the liquidity position of the banks.
Central banks pump billions into system Guardian (27/9/08)
Bank of England pumps £55bn into credit markets Times Online (26/9/08)
Where has all the money gone? BBC Magazine (15/10/08)
||Explain why the Bank of England needed to boost liquidity in the money markets.
||Using diagrams as appropriate, show the impact of this increase in credit on the money markets. What constraints does the Bank of England face in ensuring that it achieves the desired outcome?
||Discuss whether the approach of raising liquidity is likely to be more or less effective than a change in the regulatory framework.
Late March saw the auctioning by the Bank of England of £10.9bn to boost liquidity in financial markets. This was £5bn more than had been expected and so should help ease the liquidity position for cash-strapped banks and other financial institutions.
When the rivers run dry The Economist (6/3/08)
Bank of England answers pleas with £5bn injections Times Online (21/3/08)
||Explain what is meant by liquidity.
||Assess the main factors that have resulted in a shortage of liquidity in financial markets.
||Discuss the extent to which this extra liquidity is likely to help reduce the likelihood of recession in the UK.