Brookings
July 14, 2010
The Europeans are conducting critical “stress tests” of the resilience of their banks in a potential severe economic crisis, with the results to be announced on July 23rd. This is somewhat similar to the U.S. stress tests that had such a positive effect on confidence in the American banking system and economy in the spring of 2009. There are a number of reasons to expect the stress tests to produce a less dramatically positive result than in the U.S., but they have substantially more chance of success than did the previous European stress tests, which were virtually ignored by the markets. On the flip side it is possible, although quite unlikely, that the stress tests will end up scaring the markets rather than reassuring them.
The three keys to success will be: an appropriate level of rigor; transparency on the process and results; and the assurance of a back-stop for those banks that need it. Insufficient rigor would destroy the credibility and usefulness of the tests while excessive rigor could cause panic about a quite improbable scenario. (In practice, there is little chance that regulators designed an excessively rigorous test.) Keeping important facts secret would sacrifice effectiveness, since the public is not in the mood to trust governments, in light of past assurances during the financial crisis that proved to be false or too optimistic. Finally, there are likely to be banks that will be shown to be weak. Governments must have a plan to shore them up, otherwise the tests could trigger a crisis rather than restore confidence. The highly successful U.S. tests met all three conditions, although there was some grumbling at the time that the tests were not sufficiently tough. In retrospect, the rigor seems to have been about right in total, even though some of the variables were set too optimistically when viewed individually.
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