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Yoshikami: Stress Tests? No Not Really

After a highly anticipated week of leaks and rumors over how many, and which banks, will pass or fail the "stress test", the results are in. Only seven of 91 European banks flunked. Such a surprise... well, not really.

On the face of it, this seems like good news. Only seven, not a third, not half, or three-quarters, have issues. Only five banks in Spain and one each in Germany and Greece failed the test. Every major international bank headquartered in the European Union passed the tests, including Deutsche Bank and Royal Bank of Scotland. (See complete coverage of the tests here)

The state of financial institutions in the EU is healthier than investors and creditors had thought, which should boost market confidence. And frankly, that was the point of the exercise. The same type of tests helped U.S. financial firms such as Citigroup and Wells Fargo move forward from the economic downturn of 2008.

The aim of the stress test was to clear up market fears about the strength of the European continent’s banking system in dealing with the debt crisis. It was also an attempt to reassure financial markets that eurozone banks have balance sheets that could really withstand sovereign risk shocks.

"The outcome of the tests is less important than the assurances from governments and authorities that they will pursue policies to ensure stable economic growth. In Europe too big to fail is alive and well." -YCMNET Advisors, Michael Yoshikami

The EU called the results a resounding vote of confidence that "confirms the overall resilience" of the banking system. But are investors and markets left feeling more reassured… or more unsettled? Are European banks that healthy? Do we really believe that these banks can withstand sovereign risk shocks?

Many argue that the much-anticipated tests weren’t tough and rigorous enough to be credible. In an exercise arguably brought about by concerns of a sovereign debt crisis in Europe, the tests didn't actually include a scenario for a national default. Vice President of the European Central Bank, Vitor Constancio, was quoted as saying a sovereign default was ignored because "we don't believe there will be a default." Well, the perception of reality is often times a far cry from reality. Worse case scenarios often times surpass our wildest imaginations. Did we ever think Lehman Brothers would collapse?

It was a non-event to say the least.

No shocking headline news to scare the market, but neither was there any sort of reassurance for those in the camp who believe that Europe’s financial institutions really need strengthening. In total, the seven banks have to raise $4.5 billion to shore up their finances, far lower than some analysts had been predicting. Compare this to similar types of tests last year in the U.S., where 10 of the 19 banks were required to raise $75 billion.

Despite market doubts over sufficiency of criteria, markets either did not react or showed a positive reception of the tests. The cost of protection against peripheral eurozone sovereign default declined. Asian shares rose and the euro extended gains on Monday as solid U.S. corporate earnings and strong eurozone data offset any negative sentiments towards the stress tests.

The European Debt Crisis - See Complete Coverage
The European Debt Crisis - See Complete Coverage

The bottom line is the outcome of the tests is less important than the assurances from governments and authorities that they will pursue policies to ensure stable economic growth.

In Europe too big to fail is alive and well.

Good or bad, the markets are demanding evidence that financial collapse in Europe is not in the cards. Stress tests are one way to make that statement. Even if the stress tests aren’t really that stressful.

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Michael A. Yoshikami, Ph.D., CFP®, is Founder, President, and Chief Investment Strategist of YCMNET Advisors, Inc., a registered investment advisory firm (www.ycmnet.com). He oversees all investment and research activities of YCMNET. He is a respected lecturer speaking frequently on market issues, tactical asset allocation, and investment strategy. Michael and YCMNET were ranked as one of the top 100 investment advisors in the United States for 2009 by Barrons. He appears regularly on CNBC and CNBC Asia and can be reached directly at m@ycmnet.com.