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Are Europe's banks sleepwalking to disaster once more?

Finance Blogger: Ian Fraser Ian Fraser

It would be crazy if, three years after the start of the last one, Europe was to sleepwalk into another banking and financial crisis. But there are plenty of commentators who believe that is exactly what’s happening right now.

In recent days there has been a slew of promising half-year figures from banks across the continent, which ought to suggest the banking sector is on the mend. Many bank analysts issued buy notes.

However the banks remain more vulnerable than their financial resurgence, mainly a consequence of falling provisions for bad debt and greater "pricing power" thanks to weaker competition, suggest. Neil Dwane, chief investment officer at asset managers RCM, is warning that Europe's financial and regulatory establishment is being complacent about the risks ahead.

In particular, he said that neither the Basel Committee on Banking Supervision, nor the Committee of European Banking Supervisors (CEBS) which organized the recent European "stress tests", are taking a sufficiently tough line with the banks, especially where capital adequacy is concerned.

Dwane said the European bank stress tests, which were sailed through by all but seven of the 91 participating banks on July 23rd, provided a false sense of comfort. There are similar issues with the Basel III rules which, following fierce lobbying and economic scaremongering from banks, have been watered down and delayed.

Pedro Noronha, chief executive of Noster Capital, recently told the Daily Telegraph that people are burying their heads in the sand about the extent of the challenges the banks face. He is shorting five major European banks, including the UK's Barclays, Spain's BBVA, and Switzerland's UBS.

"Two months ago everybody was in a panic about the sovereign debt crisis, and now it's like everybody is going on holiday and everything is fine"

He believes that the methods used by CEBS to assess European bank's ability to withstand future "stress" were fundamentally flawed.
"The point of a stress test is that you stress something until it breaks. These tests included a ridiculous definition of tier-one capital and allowed some banks with... 1.7% to show levels above 6%," he said.

The US tests of March 2009 revealed that 10 large US banks required a total of $74.6bn in extra "capital buffers". But the European ones, which failed even to take account of the risk of a Greek sovereign debt default, have been dismissed as a glorified PR exercise, designed solely to bolster flagging share prices. Singapore-based investor Jim Rogers told CNBC that the European tests were:
“ a total waste … That was just PR and little else… Yes, they make things look better for a while. Are they really better? No.”

The tests' results were based on the premise that European banks could rely on stronger economic growth to ensure they can recapitalise and stabilize themselves. Some commentators detect the influence of a Micawberish, "delay and pray" mentality. The trouble with such an approach is that if stronger GDP growth fails to materialize—a distinct possibility given the likely fallout from governments' fiscal austerity programs and the bloodbath that could follow a Greek default—some banks will be scuppered.

A key millstone for Europe’s banks is that they have hundreds of billions of euros of short-term wholesale funding to refinance over the next couple of years, much of it provided at below-market rates by central banks including the ECB and governments. In the UK alone banks must replace £450bn of wholesale funding across 2011 and 2012, according to Morgan Stanley. Given that they passed the stress tests with ease, this ought to be a walk in the park for them. However, the omens are not good.

The Bank of England estimates UK banks must raise £25bn a month to meet these targets, but they're currently only managing to raise £12bn a month, which doesn't seem like a recipe for a stress free life.

Overall, Dwane seems exasperated by what he sees as the complacency of bankers and of Europe’s financial establishment, and their apparent inability to learn anything from the financial crisis of 2008.
“Many market participants have been waiting for renewed and more rigorous rules to come from Basel to correct the previous wrongs and the credit arbitrage seen in the 2008 financial crisis. However, the new Basel III recommendations have been significantly watered down. This means that, either the banking lobby has remained strong enough to influence at a political level to soften regulations, or deeper analysis of the banking sector made it clear that it is not currently robust enough to cope with the appropriate regulation needed to avoid a similar financial crisis occurring in the future.”

Further reading on stress tests and bank regulation

Tags: banking , central banks , financial crisis , GDP growth , regulation , UK
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