EU stress tests: European banks must wish they had endured a tougher stress test. The European Banking Authority's examination, published on July 15, gauged what happened to their capital under a two-year adverse shock. But the assumptions made about bank funding costs in difficult markets already look pretty tame.
It's not easy to establish what banks are having to pay for long-term wholesale funding. One proxy is spreads on bank credit default swaps, which represent the cost of insuring against a default. Worries about banks' exposure to troubled sovereigns have pushed these above levels seen in Autumn 2008.
That's not the only evidence of funding getting tighter or more expensive. US money market funds have shortened the maturities of the short-term funds they extend to European banks, Fitch said on Aug. 22.
Comparing current CDS spreads with the EBA's own assumptions on the average cost of funding that each European bank would face in an adverse shock is eye-opening. The tests assumed that Société Générale, for example, would see its funding cost almost double from 136 basis points to 260 bps by the end of 2012. Yet, the cost of insuring the same bank's senior debt for five years is now over 300 bps. Dexia and other Greek, Irish and Portuguese banks' CDS trade above their EBA-stressed funding costs by a much wider margin.
Banks can cope with such conditions temporarily. However, if actual funding costs are this high and stay elevated, it becomes harder to rely on EBA's conclusions about bank solvency. Banks will generate less profit and have lower capital ratios if the euro 4.8 trillion of interbank and wholesale funding maturing before January 2013 costs more than the EBA assumed.
The good news is that almost 60 percent of European bank assets are funded by deposits, which are much less affected by market sentiment. And, most big banks, including SocGen, have rolled over most of the funding that needed refinancing this year. Moreover, bank CDS may no longer be as reliable an indicator of bank funding costs, because the instruments are being used to hedge exposure to sovereign debt.
Even so, for so-called "adverse" liquidity costs to be overtaken only a month after the test cannot be good. The EBA conducted dedicated liquidity tests earlier this year, but did not publish its findings. Investors will just have to hope that it was tougher than the solvency test data imply.
