Stress tests: a success for cooperation and transparency – and also very good for Spain

Xavier Freixas interviewed by Viv Davies, 13 August 2010

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<p><em>Viv Davies interviews Xavier Freixas for Vox<br />
<p><em>August 2010<br />
<p><em>Transcription of an VoxEU audio interview []</em></p>
<p><strong>Viv Davies: </strong>Hello and welcome to Vox Talks, a series of audio interviews with leading economists from around the world. I'm Viv Davies from CEPR. It's the fifth of August 2010 and I'm talking to Professor Xavier Freixas from the Universitat Pompeu Fabra in Barcelona about the outcome of recent stress tests imposed on European banks and, in particular, the impact of the tests on Spain. I began by asking Professor Freixas what he thought the main objectives of the stress tests were in the first place.</p>
<p><strong>Professor Xavier Freixas: </strong>To answer that, I'd like to see it in the context. So, on the first in March, it was decided to have a stress test as the European community of banking supervisors have already done before. But then, with the Greek crisis, there was a theory that there was a lack of information and transparencies to the market that was hurting solvent, liquid, serious banking institutions. And so, there was a pressure by those banking institutions to have more transparency and this was, I think, the main driving force that has led to have such an exercise with the results being available and everyone being able to perform additional tests on the results.</p>
<p>I think that there were really two objectives that are different and, therefore, your perspectives on how good the stress test results are dependent on those issues. So first, there is one objective and that is to have more transparency in order to identify what are the fragile banks. And that's one thing.</p>
<p>So, to discriminate among the top, solvent, sound banks and those who are in bad shape: That was clearly one objective, obviously promoted by those banks that are successful in this crisis, so that's a relative thing.</p>
<p>But then, the second objective that is related to the strain on budgetary resources is to see whether if there are systemically important financial institutions at risk, whether the county has sufficient available resources to support and restructure these &quot;too big to fail&quot; institutions.</p>
<p>The stress test is great regarding the discrimination, but it's clear to see that there are banks that are really in good shape and others, several in particular, that need additional resources. That's one thing.</p>
<p>Then whether there are banks that need more resources whether governments in those countries are able to provide those resources. Then it depends on how you design the stress test. It's more sensitive to what you want to be assumptions of the stress test. If you have a catastrophic debt, then no government has sufficient resources to bail out the many banks in the country. So this is much more sensitive.</p>
<p>But the discriminating exercise is great because then we know, relatively to each other, how banks are performing.</p>
<p><strong>Viv: </strong>The results of the stress tests show that only seven out of 91 banks failed to meet their capital requirements. Were you surprised by this? Many commentators are of the opinion that the tests weren't robust enough. They suggest, for example, that the capital adequacy requirement at six percent was too generous and that there were also significant discrepancies between the assumptions that we used in different countries. What's your opinion on the question of robustness? Did the tests ask the right questions or do you think that consistency and credibility were perhaps sacrificed?</p>
<p><strong>Prof. Freixas: </strong>There is, of course, one interesting thing. Well, this is related to the previous question. If you prioritize the objective to discriminate among banks, then this is a minor criticism. If the key issue is whether Europe has sufficient budgetary resources to bail out the banks that are in trouble, then it's critical to have the right assumptions. My view is rather that the main exercises are to provide transparency to the market so that the solvent banks are able to borrow from the market more easily in spite of being located in such or such country, in countries that have budgetary restraints.</p>
<p>Now we go to the question, are the assumptions too soft? Well, I would tend to say that the starting point of the exercise is today's housing prices as they are. So, we're considering an additional fall in the prices, and we're picking up the starting point to-date prices so that the initial point is not taking into account the bubbles that were in the prices a few years ago. From that perspective, it's not having a reasonable drop is not a bad assumption.</p>
<p>Now, the exercise considered two scenarios: The benchmark, which is quite generous I think and the adverse scenario, which obviously is the interesting one. In the adverse scenario, I think the macroeconomic assumptions are rather optimistic, but on the outside, the risk assumptions are quite rigorous.</p>
<p>The adverse assumptions of 4.4 percent losses in corporate loans and 2.1 percent in retail for fall, I think this contrasting with the optimistic microeconomics scenario, this is a serious increase in the losses of the bank. From that perspective I think the assumptions are quite good and difficult.</p>
<p>Now, one thing we can say is that the market reaction was important to the stress test. So, if the criticism regarding the assumptions being too generous was founded, then of course the market would not have reacted in this positive way. There was genuine new information that was coming from the exercise.</p>
<p><strong>Viv: </strong>Five of the seven banks that failed the stress test were Spanish cajas or savings banks. Why did they fail and what does this now mean both for those particular banks and for the Spanish banking system?</p>
<p><strong>Prof. Freixas: </strong>First, why did they fail? A combination. What comes to mind is the phantoms of Chuck Prince that when the music goes on, you get up and dance. Indeed this was hurting into the same investment and strategy, and this is reinforced, because you see all of your competitors are investing in real estate mortgages. And so the problem was losses in real estate development, so those financing real estate development had to resell to these cajas.</p>
<p>In addition, this comes at a point in time where cajas begin to compete more with one another and try to expand the market outside their region. The cajas are small financial institutions which are quite regional. So, these cajas start lending in regions and in markets which they are not so knowledgeable about, with the so called winner's purse.</p>
<p>That is when you enter a new market, you start basically getting the borrowers that nobody else gets. And the statistical evidence on this tells us that after three years, you have losses that are due to the fact that you are entering a new market. So, this has, combined with the first point--with the cajas investing in real estate development--they have combined this with excessive growth outside their own zone of competence, outside their own natural market.</p>
<p>The third point is that there has been bad corporate governance. There is a very interesting paper by Vicente Cu&ntilde;at and Luis Garicano from the London School of Economics&mdash;they&rsquo;re both Spanish, from London School of Economics&mdash;on performance. And they show that the loan losses of the cajas depend on the board of directors. And when the managers do not have graduate studies, then you have one percent additional loan losses. If they don't have any banking experience then you have one percent additional loan losses. Then finally, if they have been elected to political position, then you have to add one percent additional loan loss.</p>
<p>Now, the new law for the cajas implies that in order be a manager for the cajas&mdash;this is quite recent&mdash;you cannot have held any political position, which is great. That will help a lot. And finally, the final nail in the cajas' coffin is the fact that you have a negative growth environment. You have negative growth, and this will affect all Spanish banks, of course. Those that are well and will survive, like Santander, BBVA, which have a fraction, a large fraction of their business in Latin America, of course, are less affected by the negative growth in Spain.</p>
<p>So that's, how will this affect the Spanish system? Well, it has affected the Spanish system, because the market has reacted to this by considering all Spanish banks as a uniform type of financial institution. Well, now the stress tests have been very good for Spain, and that&rsquo;s why the Bank of Spain has chosen very strong assumptions, very rigorous assumptions. Thirty percent drop in real estate prices, for instance. So that the financial markets are able to see the difference between a caja and, say, Banco Santander, which are completely different animals, even if both are in the same jurisdiction.</p>
<p><strong>Viv: </strong>During the last week, we've seen international investors rushing back in to fund the activities of Europe's banks, in spite of the criticism over the robustness of the tests. Some commentators have suggested that this is the result not just of the outcome of the stress tests, but also a consequence of the relaxation of the proposed Basel III bank regulations. What do you make of this renewed confidence and buoyancy? Is it justified?</p>
<p><strong>Prof. Freixas: </strong>Well, I think this is very positive reaction from the market. I like to think that there is something in the etymology of word, and the turning point, this diakr&iacute;seis--in the original Greek, it's from the Greek word to separate, to decide or to judge--and the stress test has indeed discriminated among top, well-kept, alive, efficient banks and those who are not. So, what we expect that is, what we expect from the crisis in general, is an efficient banking system. And this we can only have if we have a wave of mergers and acquisitions. Takeovers, whether hostile or not. And so what we need is, what we want to see is definitely some activity on that front. Now, of course, if all banks are limited in their funding, if all banks are facing market liquidity, funding liquidity, then this will never develop.</p>
<p>With the stress tests, the market has more information so that it will be easier for the well-kept, alive banks to access resources and then maybe to buy, say, assets from other banks, or to buy other banks. The example I have in mind is on August 4th, or August 3rd, two days ago. Santander bought 318 branches of the Royal Bank of Scotland. This means that Santander is now confident enough that it has access to liquidity and, in my view, this is directly related to the stress test.</p>
<p><strong>Viv: </strong>But, given the extent of bank debt in the Eurozone generally, with its high loan to deposit ratios, how vulnerable do you think the banking system really is in Europe? Do you think it could withstand a severe shock such as, for example, a sovereign default by a Eurozone member?</p>
<p><strong>Prof. Freixas: </strong> This is an unlikely event, and this is a question which is difficult to answer. To some extent it depends on how the default is managed. It may be the case that we are thinking of a default, like an Italian default, where you restructure and then the three months become ten years, or something like that. If this is the case then the European Central Bank can manage and could do something about it. If not, things are more complicated but nevertheless the stress tests have shown one interesting point that some of the banks that are more vulnerable to sovereign risks, are those banks that are precisely in Germany or in France. It's good news because the public finances in those countries are much better than those, than the public finances in Spain or Greece of course.</p>
<p><strong>Viv: </strong>Generally, do you think the whole exercise of stress testing at this time in Europe has been a successful project? A successful initiative?</p>
<p><strong>Prof. Freixas: </strong>Definitely. And while in the US it's easier to coordinate because, of course, there are several regulators but there is a main regulator, which is the Fed. Here, it really shows how the Fed is becoming a serious European banking authority, and able to coordinate a complex exercise. Of course, it has to lead with assumptions presumably with each country regarding what is a reasonable assumption for real estate drop. In Austria, something is an increase of 50 percent, is what is assumed. But still, I think it's very positive and unprecedented. I think it's quite a success in coorporation and quite the success in transparency. So overall I'm very positive in how successful the exercise has been. And of course, it could be improved, definitely. And of course, you could say, rather than G 1, I would have preferred to have core G 1 excluding those actual [inaudible], those types of securities. But, overall, it is a minor point.</p>
<p><strong>Viv: </strong>Xavier, thanks very much for speaking to us today.</p>
<p><strong>Prof. Freixas: </strong>Thank you, Vivian.<br />

Topics:  EU institutions Global crisis International finance

Tags:  Spain, stress tests, Eurozone crisis

See also's Global Crisis Debate: The Risks of a Crisis in Central and Eastern Europe Are Bigger Than You Think

The interview was recorded on 05 August 2010.

Professor, Universitat Pompeu Fabra; CEPR Research Fellow


CEPR Policy Research