In an effort to ascertain the sustainability of its financial system, European banking authorities ordered a stress test on all its banks. The results of these tests were released last week. The reaction of the financial markets to the results was, at best, mixed.
A “stress test” on banks is pretty much akin to what that phrase means in the case of a physical examination.
During a “stress test”, a person is run through a treadmill with all his vital signs electronically measured. This procedure is supposed to check how the patient’s body will perform under stress.
For banks, a “stress test” involves running the institution’s financials through several stress scenarios. This is a computer-aided procedure meant to determine how viable the bank will remain under several stress conditions. European bank regulators want to know how their financial system will fare in the event of a relapse in the recession.
I am surprised the Europeans are only now performing stress tests on their banks. In this country, the BSP has required all the banks to perform stress tests on their financials periodically. This is part of the risk management regime all financial institutions ought to maintain in this age of volatility.
Most of the European banks passed the stress tests with flying colors. A cluster of medium-sized Spanish banks called cajas did not. That is the reason market reaction to the outcome of the tests was mixed.
The Spanish cajas are poorly regulated institutions. They are mongrels of what, in our case, we call thrift banks, rural banks and small commercial banks.
The cajas were often run by politicians or, in several cases, priests. The bankrupted Monte de Piedad bank that used to be run by the Catholic Church comes to mind. What also comes to mind are those banks run by the Legacy group that collapsed a couple of years ago.
These cajas are not the most efficient models of how banking should be done. They were outlets for cheap credit that the Spanish government made available to help finance the country’s economic growth. Because of the cheap sources of wholesale credit provided by the Spanish government, the cajas appeared sustainable. When the cheap credit dried up, however, the cajas have now proven to be vulnerable institutions.
The cajas were not required to regularly mark-to-market the value of their assets. Because of this, the cajas might appear more robust than they actually are. Marking-to-market is an accounting procedure where a bank’s assets are regularly re-priced to reflect prevailing market prices.
Because the cajas were not regularly marking-to-market, their financial statements did not capture the massive decline in property prices that has been happening in the Spanish economy. A bank normally holds a large amount of real estate assets as collateral for lending that has been made.
Spain, we know, now has the highest unemployment rate in the entire Euro zone. Unemployment stands at 20%. Effective consumer demand in Spain has therefore been on a downward trend.
More important, Spain now has about one million housing units unsold even as property prices have been substantially declining. Those unsold housing units were financed by the cajas and are likely held as collateral by the same lenders. That is really bad news about the health of Spain’s financial system.
On the books of the cajas, the unsold real property is booked according to their prices at the time loans were made. Today, those assets are worth very much less than how they remain priced in the books of the cajas. This is a variant of the subprime crisis that brought the US financial system to the brink of a meltdown a couple of years ago.
Because the cajas have now realized that they are actually less solvent than they thought they were, they have shut down lending abruptly. Few other large banks outside the European Central Bank would now want to lend to them. Hundreds of small and medium scale enterprises in Spain that depend on the cajas for financing are now caught in a lurch.
Because of the tightening of credit, it is now feared that Spain is in danger of reverting to deep recession. That could drag down other economies in the Euro zone.
What compounds the problem with the cajas is the fact that the Spanish government is in the midst of a comprehensive austerity program. This program is being undertaken because the level of Spanish debt, like Greece’s, is deemed unsustainable.
The austerity program will not cure the unemployment picture. It will, in all likelihood, aggravate it.
The pay cuts, withdrawal of subsidies and the closure of even more financially-starved enterprises will deepen the trend towards a serious recession. The Spanish government is in no fiscal position to mount an economic stimulus program. It cannot continue supporting the flow of cheap credit to the cajas. Some of them might go under over the next few weeks.
This is not a pretty picture. There are demonstrations in the streets of Spain these days, protesting the belt-tightening measures. Austerity is never popular.
To make things worse, the economic tensions have reignited ethnic tensions. In the Catalan region, communists are marching beside right-wing nationalists demanding more autonomy from Spain. They are blaming Madrid for the economic woes besetting everyone.
This is the sort of outcome we should try to avoid here by maintaining the highest quality regulation of our financial and fiscal affairs.