Exclusive: Buiter – “The ECB would fail EBA stress tests miserably”
The European Central Bank would fail European Banking Authority stress tests, but this is not the issue the European markets should be worried about, says Willem Buiter, one of the world’s most distinguished macroeconomists
The European Central Bank (ECB) would fail European Banking Authority (EBA) stress tests, which are usually reserved for corporate financial firms, says Willem Buiter, chief economist at Citi. However, this is not the key issue that Europe should be worried about or concentrate on, he adds.
“Yes, the ECB would fail the EBA stress test miserably but this is a complete nonsense issue,” says Buiter, a former consultant to the International Monetary Fund, the World Bank and the European Commission. “It is irrelevant to subject a central bank to a form of stress testing that is used for corporations and financial institutions, as the ECB’s loss absorption capacity, its economic capital, bears no relationship to conventional forms of regulatory capital or equity.”
The EBA, the European Union’s watchdog, started to impose tougher new stress tests on lenders to document and provide transparency around their reserves and systems, as an official way of gauging the level of risk a financial institution held and whether it would be able to cope with an economic crisis.
In July, the EBA revealed the results of the stress tests, which “are aimed to assess the resilience of 90 banks across 21 countries against an adverse but plausible scenario, and banks therefore [are] incentivised to strengthen their capital positions ahead of the stress test”.
In results published on July 15, the EBA said that at the end of 2010, 20 banks would fall below the 5% Core Tier 1 Ratio (CT1R) threshold over the two-year horizon exercise, with an overall shortfall of €26.8 billion.
Buiter says that all central banks, not just the ECB, should not and cannot be subjected to the same form of tests.
“Even the ECB’s non-inflationary loss absorption capacity is massive – it could easily reach €3 trillion or more,” says Buiter. “Even if the ECB were to incur a €1 trillion worth of losses from Greek sovereign default, it would carry on and live to see another day, meeting all its financial obligations and not having to print money on a scale that would threaten undesirable inflation.”
Non-sovereign financials, under the EBA stress tests, would usually incur a form of warning through its national authority, should it fail the tests. The EBA would issue a formal recommendation stating that national supervisory authorities should require banks whose CT1R falls below the 5% threshold and to “promptly remedy their capital shortfall”.
“The EBA notes that this is not sufficient to address all potential vulnerabilities at this point,” the EBA states. “Therefore, the EBA has also recommended that national supervisory authorities request all banks whose CT1R is above but close to 5%, and which have sizeable exposures to sovereigns under stress, to take specific steps to strengthen their capital position. These would include, where necessary, restrictions on dividends, deleveraging, issuance of fresh capital or conversion of lower-quality instruments into Core Tier 1 capital.”
Market participants have voiced concerns over how the ECB would be undercapitalised if its balance sheet was subject to the EBA stress tests and that it is still not transparent at to what level the ECB bought sovereign debt in the past.
It is not known what the ECB’s outright holdings of Greek sovereign debt are through the Securities Markets Programme, but “it is widely estimated to be around €40 billion [at purchase value, possibly €50 billion at face value],” say Citi economists.
However, Buiter has emphasised that even in the event of any losses inflicted by a Greek sovereign default, the question of whether it is undercapitalised is not as urgent or applicable compared to a corporate, and the ECB could live comfortably with CDS being triggered or not.
“Essentially, a central bank can print legal tender and, if necessary, can make up for any losses by borrowing against its future ability to create central bank money,” says Buiter. “This is not necessarily a highly attractive option, as excessive recourse to central bank money creation would create unwanted inflation. However, even if the central bank only prints enough money to keep inflation at 2%per year from now on, it would be able to survive massive losses on its balance sheet, as large as €3 trillion according to our calculations.”
The Citi Economic Research team says the paid-in capital of the ECB (€5.4bn) or its subscribed capital (€10bn), or even by the capital plus reserves of the Eurosystem (about €81bn), is not a concern because even regarding conventional loss-absorption capacity, the Eurosystem as a whole is well equipped – in addition to the €81bn of capital plus reserves, there is more than €300bn worth of loss-absorbing valuation gains on gold reserves on the Eurosystem balance sheet.
“Of course, these losses do, ultimately, come out of the pockets of the euro-area taxpayers, who will not receive the dividends or profits from non-inflationary central bank money creation that would otherwise have come their way," adds Buiter. "Central banks, such as the ECB, are qualitatively different from commercial banks, therefore subjecting them to the same field of tests is irrelevant."