In Latest European "Stress Test" Farce, ECB Assumes No Deflation Even Under Severe Systemic Shock
In what is now an annual attempt by regional central banks to shore up confidence in their insolvent banking systems (because if they were solvent, there would be no need for such optical gimmicks as "stress tests"), yet which end up nothing shy of an all out, humorous farce, earlier today the EBA published its methodology for the 2014 EU-wide bank stress test. Before we go into the details, a quick refresher on why instead of boosting confidence in banks, these periodic wastes of taxpayer funds achieve anything but. After all, who can forget that back in 2011 it was none other than Dexia that was supposedly the best performing bank in Europe.
Of course, Dexia was promptly nationalized shortly thereafter after it was Lehmaned.
But it is not just Europe: America's own Fed cleared the 2014 US stress test-participating banks to issue more capital to shareholders just one month before Bank of America revealed that it had botched its calculation of its regulatory capital, and as a result was scrapping its capital return plan.
Some supervision; some confidence building...
But back to Europe where as noted above, earlier today the EBA published its common methodology and scenario for the 2014 EUwide bank stress test. The adverse scenario covers the period 2014 to 2016 and at least on the surface is generally tougher than the adverse scenarios in previous similar exercises, resulting in a severe negative deviation of EU GDP growth of 7% from its baseline level by 2016.
So far so good. But where the whole thing disintegrates into yet another sham spectacle confirming just how insolvent European banking truly is, is one simple observation: not even under the adverse scenario does the ECB contemplate the possibility of deflation!
That's right - so atavistic is Europe's fear of deflation, that even in what is supposed to be a purely hypothetical scenario which by definition should cover all unpleasant possible outcomes, did it not cross the mind of the test arranger to speculate that Europe, which already is struggling with deflation and will fudge each and every inflation print to make inflation appear higher than it really is, could enter outright deflation.
Needless to say, the glaring omission of this most probable path for European asset prices, makes the latest Stress Test immediately null and void. What is worse, the fact that the ECB made it a point of excluding this possibility, shows just how terrified Europe is of declining prices (for which Draghi can thank his colleague Kuroda who has been engaging in a historic episode of deflation export for the past year), and that should deflation indeed flare up in Europe even more, then all bets are off.
Here is SocGen's take:
On inflation the adverse scenario lowers inflation by 1.3pp in 2016 compared with the baseline, resulting in still positive inflation of 0.3% in the euro area. Noteworthy is that among the larger euro area countries, France would be the only country to enter deflation in 2016, while both Italy and Spain would have higher inflation than Germany. While these scenarios are static, assuming no change in commodity prices and monetary policy, they suggest that it would require a rather big shock in the euro area to see a clear deflationary scenario developing for the area as a whole. This is somewhat surprising given the recent vivid debate on whether the euro area is already close to deflation or not.
As we said, superficially at least, the stress test is said to be tougher than any previous one. What "tougher" means however in the context of a world where banks (as Bank of America did) can and will openly fudge and make up whatever numbers they wish, is debatable. Here are the details:
Stress tests tougher than in the past, but banks may also be better prepared Compared with previous stress tests, the new adverse scenario is both more demanding and long-lasting (3 years). As regards, GDP growth, the negative deviation now stretches over three years, implying a decline of 7% for the EU, compared with a deviation of around -2% per year in the last Stress Test. Also the decline in house and stock prices in now more pronounced while the rise in bond yields is significantly higher. The rise in short-term interbank interest rates is however more muted this time, while the change in the labour market is broadly similar. While this all suggests a tougher test for banks, banks are likely also in a better position in terms of capital and earnings than they were in the past which should mitigate the impact.
On top of the common shock to short-term interbank rates, the ESRB also includes a more generic shock to EU banks’ funding access, capturing both cyclical and structural forces. Interestingly, the cyclical factors are said to be “rooted in concerns about insufficient balance sheet repair due to doubts about the public backstops available for the Comprehensive Assessment”, which is in line with the ECB’s previous criticism on the progress with Banking Union. This shows an encouraging willingness by the ESRB to acknowledge that the slow progress with Banking Union can have tangible costs.
Here we will reserve our right to laugh: after all it was the IMF itself which said in August of 2013 that the "Eurozone Funding Shortfall Rises To Over $4 Trillion, Increases By More Than $500 Billion In A Year." In other words, all Europe can hope is to kick the can indefinitely and pray nobody asks to look under the cover of what is really happening, and certainly not force the ECB to use its magical, and still completely non-existent OMT program.
But what is the straw that breaks the camel's back is the following blurb:
No deflation expected in the euro area even in the adverse scenario (!)
This scenario analysis naturally represents a relatively static view, providing a snapshot of shocks and bank’s balance sheets at a particular point in time (Q42013). For instance, no changes are assumed on oil, non-oil commodity prices or monetary policy. Interestingly, even if the magnitude of the shocks is larger in this exercise, the effect on inflation appears to be more muted and delayed. With a larger drop in GDP growth than in 2011, inflation is still only expected to decline by 0.1 and 0.6pp compared with baseline in the first two years, whereas in 2011, the decline was 0.5 and 1.1pp in the first two years. This may relate to the fact that inflation now is much lower, and possibly stickier, but it also suggests a surprising resilience to a negative growth and financial market scenario. Interestingly, only France (along with five other euro area countries) is expected to see negative inflation in 2016, whereas both Italy and Spain would have higher inflation than Germany. A relatively large shock would thus be necessary to tip the euro area into deflation, possibly larger than what is currently commonly assumed given the already vivid debate on whether the euro area is already close to entering a deflationary scenario.
This points to the difficulties in designing realistic scenarios (without affecting expectations), with success only possible to establish ex post. Still, progress has been made from previous Stress Test exercises in terms of stringency, length and transparency of the adverse scenario, which should ultimately benefit the robustness of the upcoming Stress Test.
Yes, progress, from one fabricated and completely worthless "test" to another, neither of why has any utility whatsoever. But at least someone, somewhere is expected to feel more "confident" about European banks (of which Deutsche Bank as we observed yesterday, has a total notional derivative position of $75 trillion, or 20 times more than the GDP of Germany).
And since our running commentary on this particular farce from the central bank toolkit has been well-known since our running commentary on the first 2010 European stress test, we will leave it to SocGen instead:
One could question the pass-through into inflation or whether the (ECB’s) baseline inflation outlook in fact constitutes a relatively optimistic scenario.
Translation: even SocGen, with its own share of balance sheet issues and happy recipient of ECB generosity for years, thinks the latest and greatest stress test is a joke. In that case what is everyone else supposed to think?
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