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Emerging markets can learn from America’s bank stress tests

Five years ago next Tuesday, an embattled U.S. Treasury announced that it would conduct "stress tests" of America's largest banks. The idea was to reassure the markets of the stability of solvent institutions, and force weaker ones to repair their balance sheets.

Some academics still question whether this exercise was rigorous enough. There is controversy, for example, about how much capital modern banks need, and how far asset prices can reasonably be expected to fall in the event of another crisis. But one thing is clear: stress tests were surprisingly effective in helping to turn investor confidence around.

(Read more: Warning: Many US watersheds failing stress test)

In February 2009 bank shares were falling sharply, and a poll by Bank of America Merrill Lynch found that investors were so nervous about global banks that half of them had allocated a smaller proportion of capital to the sector than the industry average.

Today, however, 28 percent of equity investors are overweight on global bank stocks, after a year in which U.S. banks stocks rallied by 35 percent. This is the most optimistic reading since the survey began a decade ago and the highest "overweight" of any equity sector. The securities that inspired terror five years ago have become investors' favourite pick – more popular even than technology stocks.

There are several lessons here. One is that investor sentiment can move in dramatic cycles. Another is that market participants are no longer in the grip of crisis mentality.

It is not only in relation to the banks that investors now have a cheerier view of the world. These days the region of the world most beloved of equity investors is Europe: almost half of all fund managers want to be overweight in this region, since they think the market is undervalued. A separate survey by Deutsche Bank echoes that theme: more than a third of hedge funds apparently deem Europe the most exciting place to invest.

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Elsewhere, skies are darkening. Almost a third of fund managers are now underweight in emerging market equities, a record level of pessimism – and a stark contrast to February 2009, when half were overweight. And investors think the biggest threat to growth now comes from China, the former market darling.

It is a striking reversal, and one that – painful though it may be at the moment – contains an encouraging moral for emerging markets. If sentiment has swung so dramatically in the past five years, it could swing back sooner than many now foresee.

If you look back at the trajectory of sentiment towards banks, some of the improvement can be attributed to stronger U.S. growth. Recent stabilization in Europe has been important too. But charts suggest that the turning point in sentiment and share prices was in February 2009.

That shows that credible stress tests, accompanied by measures to recapitalize the banks, can be a potent policy tool. This has big implications for Europe, given that it has hitherto produced less-than-credible stress tests (although people such as Axel Weber, head of UBS, insist that the next, third, set of stress tests due later this year will be much tougher than before).

There is a wider point too: at times of investor gloom decisive and credible government policy can sometimes act as a powerful inflection point. It is never easy to tell which event will trigger that sentiment shift; five years ago some observers doubted that the U.S. stress tests would work given that Washington had for months been in denial about the scale of the banks' problems, and repeatedly botched its efforts to sort them out. Indeed, there was concern the financial crisis could get worse,

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But as turmoil bubbles around emerging markets, investors and Group of 20 ministers might do well to ponder that lesson – and ask what it might take for one (or several) of the emerging market governments to repeat the same trick? Is there another set of tangible policy reforms that could be produced and start to turn sentiment around? If so, what might be the 2014 equivalent of a stress test?

Do not expect the answer soon; right now denial and blame is the theme of the day in many emerging markets. But do not ignore the potential for surprises in the next few years. The cure for market turmoil can turn out to be as surprising as the cause.

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