Stress Tests Show Regulators Won't Clobber Banks

Friday, 23 Jul 2010 | 2:49 PM ET

Today’s stress tests of European banks did not weigh as heavily on markets as many expected. Despite skepticism about the criteria of the tests—assuming no chance at all of a sovereign default—and the conclusions—only seven banks flunked—the market seems to accept the conclusion by bank regulators that Europe’s banks are not as sick as feared.

What many market watchers have missed, however, is the fact that this conclusion by regulators is in some sense, self-fulfilling.

European Central Bank
European Central Bank

By declaring that the banks are less risky than bearish investors and pundits believe, they take away at least one very important risk the European banks faced—the risk that regulators would force a plethora of banks to raise capital all at once.

To put it differently, the stress tests raised the possibility that regulators would find bank capital badly wanting. Banks forced to raise capital would see their share prices collapse as shareholders feared dilution, regardless of whether the new capital came from the capital markets or government rescue funds. This would make the banks’ balance sheets even shakier, perhaps requiring another round of bailouts.

The results of the stress tests largely swept away the risk of increased regulatory capital requirements for all but the seven banks that failed the stress tests. The great risk of a government led capital crisis in the banks has vanished.

Take a look at the decision by the European regulators to assume that the risk of a sovereign default has been eliminated by creation of the European Financial Stability Facility and similar measures. Of course, it remains debatable whether or not the sovereign bonds of Europe’s most financially troubled nations could still default.

But the very fact that the European regulators have announced that they will not take default risk into account when judging a bank’s health, takes away the risk that banks will be forced to hold more reserves against this risk.

In short, what the stress tests unarguably demonstrated was not that Europe banks are healthy—that’s still arguable—but that regulators view them as healthy and won’t be enforcing any new, drastic rounds of capital raising anytime soon.

They were a test of regulatory forbearance and forbearance won.