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Some Banks Are Too Big to Fail?

By Jordan DiPietro – Updated Apr 6, 2017 at 12:29PM

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The stress test exercise leaves many questions unanswered.

A few months after the Greek contagion started spreading like wildfire through the credit markets, it seemed as if the EU was doomed. Within several weeks, Portugal, and then Spain, went through credit rating downgrades similar to what Greece had previously undergone. It looked as if the end was near.

We will calm your fears!
Rest assured, European finance ministers got together and decided to stress-test 91 banks to calm the credit markets and reduce fears of a broad collapse of EU financial institutions.

Accordingly, the markets rejoiced (albeit temporarily) as investors figured that transparency and accountability would help calm the waters and institute the shoring up of capital as needed. German Finance Minister Wolfgang Schaeuble has said the tests were "an important step to end the uncertainty which is persisting on the markets regarding the situation of banks in Europe."

Not as easy as it sounds
However, as more and more information emerged about the rigor of the stress tests, it seemed as if the tests were not exactly too "stressful." According to The Wall Street Journal, the tests didn't actually include the possibility of a sovereign default. Rather, the tests focused only on debt held in banks' trading portfolios. This means that any sovereign debt that is held to maturity would not be considered in the stress tests.

What does this mean? First, it means that the tests have to be taken with a grain of salt. Sovereign default was, and is, the biggest concern -- and by not including a bulk of those liabilities as part of the "shock" scenarios, the EU is basically saying that certain banks are just too big to fail. If say, a large Spanish bank defaults -- don't worry, the EU will provide unlimited financial backstop and support. Hurray!

Consider some of the results from the tests that were released this past Friday.

Two of Ireland's biggest banks, Allied Irish Banks (NYSE: AIB) and Bank of Ireland (NYSE: IRE), passed the exam, although questions surround the legitimacy of the findings. For instance, Allied Irish Banks passed the test primarily because included in its calculation was the expectation that it would be able to raise $9.6 billion by the end of the year. But depending on the friendliness of the capital markets, by year end is a risky proposition, at least in my book.

Only one Greek bank failed the test -- state-controlled ATE -- which possibly surprised some investors, as much attention has been given to the National Bank of Greece (NYSE: NBG) in the past few months. So far this year, the stock has plummeted 43% as investors were concerned over the bank's exposure to sovereign debt.

Despite the fact that Spain was adamant that results of the tests be published publicly, results were mixed. Ninety-five percent of the country's institutions were tested (much more than the average 65% for other EU members), and five of the 27 tested failed to meet the Tier 1 capital ratio. Banco Santander (NYSE: STD) and Banco Bilbao Vizcaya Argentaria (NYSE: BBVA), two of Spain's largest banks, both passed with flying colors.

Other banks that passed and are worth noting are U.K.'s Royal Bank of Scotland (NYSE: RBS), Barclays, Lloyd's, and Germany's Commerzbank and Deutsche Bank (NYSE: DB).

The Foolish bottom line
Only seven of the 91 banks that were tested have to raise reserves, and on the surface, that's a good thing. But not including sovereign default held to maturity in the tests severely hampers the test's credibility and makes EU finance ministers look as though they threw up a lob, allowing most banks to easily hit this one out of the park.

What do you think -- were the tests stringent enough or was it just a short-term strategy to try to calm markets? Sound off in the comments below!

Jordan DiPietro owns shares of National Bank of Greece. Try any of our Foolish newsletters today, free for 30 days. The Motley Fool has a disclosure policy.

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Stocks Mentioned

NatWest Group Stock Quote
NatWest Group
NWG
$4.99 (2.04%) $0.10
Deutsche Bank Stock Quote
Deutsche Bank
DB
$7.40 (-0.80%) $0.06
National Bank of Greece S.A. Stock Quote
National Bank of Greece S.A.
NBG.DL
Allied Irish Banks, p.l.c. Stock Quote
Allied Irish Banks, p.l.c.
AIBYY
Banco Santander, S.A. Stock Quote
Banco Santander, S.A.
SAN
$2.32 (0.43%) $0.01
Banco Bilbao Vizcaya Argentaria, S.A. Stock Quote
Banco Bilbao Vizcaya Argentaria, S.A.
BBVA
$4.45 (%)

*Average returns of all recommendations since inception. Cost basis and return based on previous market day close.

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