Will EU Fail Stress Tests?

by Anil K Kashyap, Kim Schoenholtz and Hyun Song Shin

Bloomberg
March 15, 2012

The Federal Reserve’s 2012 stress tests of U.S. banks suffered from some of the same weaknesses as the ones it conducted last year.

We hope the same won’t hold true of the European Banking Authority, which has delayed another round of exams of the region’s banks until 2013, after failing to credibly carry out its supervisory mandate in 2011.

The EBA’s swing-and-a-miss followed similar disappointing performances in 2009 and 2010 by its predecessor in this role, the Committee of European Banking Supervisors. Now, euro-area banks are deleveraging, deepening the recession by starving European companies of financing. They also lack the capital to support an eventual recovery in the region. Until the capital shortfall is measured and addressed, there will be no end to the twin sovereign and banking crises in the euro area.

When the EBA gets a fourth turn at bat next year, the authority can -- and should -- make use of a growing body of knowledge and experience regarding stress tests. And supportive actions by the European Central Bank and the fiscal authorities may raise the chances of success.

The stakes are high: Another stress-test failure would undermine the fragile consensus on policy efforts to contain the crisis, feeding a run on the region’s weaker banks.

What would a successful stress test require? Our research, conducted jointly with David Greenlaw, highlights two prerequisites for success. First, it would need the effective application of macroprudential principles, which means looking at the entire financial system.

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