There’s good and bad news in the Federal Reserve’s decision to expand the scope of its annual stress test of the nation’s top banks. Given the deteriorating economic picture, submitting the 31 largest lenders to even more scrutiny than in the previous two years makes sense. So does putting the European exposures of the top six banks under the microscope. But the Fed’s latest move will leave many on both sides of the Atlantic unhappy.
Start with the United States angle. The Fed is expanding its stress test beyond the 19 largest banks to include another 12 with $50 billion of assets or more, including Discover Financial as well as the United States subsidiaries of several foreign banks like HSBC. Considering that several midsize banks landed in trouble in the last crisis, bringing them into the fold is overdue.
The Fed is making all 31 banks run some pretty depressing numbers through their models: an 8 percent contraction in the gross domestic product, the Dow Jones industrial average collapsing to 5,700 points by the middle of next year, and an unemployment rate rising above 13 percent by 2013. The six largest banks must demonstrate they can also withstand a euro zone crash that whacks European governments and financial institutions.
The test probably means few, if any, banks will be allowed to raise dividends or buy back more stock next year. Instead, they will have to hang onto their capital. And the test ought to make it much harder to cast aspersions on the creditworthiness of any bank that passes.
But the process will take time. Banks have until January to file their results and, based on this year’s exercise, results aren’t likely to be known until April. By that time, the United States and European crises that the Fed imagines could be under way. Pity the bank that is told to raise capital in such an environment.
Meanwhile, Europe looks set to suffer even more. American banks are already reining in their exposure to the euro zone. But the mere fact that the Fed is increasing scrutiny of their exposures could accelerate the withdrawal. That increases the risk that the stress possibilities become reality.
A Troubled Haven
By the standards of the euro zone, Germany is still a haven. But as the overall area keeps looking less safe, investors are starting to notice that, for all its strengths, Germany does lie within it.
On Wednesday, a German government bond offering was badly undersubscribed; bids were accepted for only 61 percent of the 6 billion euro issue. The norm is more like 90 percent.
The bonds that were sold yielded 1.98 percent, still comfortably low as far the government is concerned. But that was 0.1 of a percentage point more than the day’s low, and yields climbed another 0.09 percentage points later. By afternoon, the German paper, or bunds as they are known, yielded 0.24 percentage points more than comparable United States debt. Just a week ago, the gap was similar but in the opposite direction.
This is far from a sign of total panic. Even so, the trend is hard to deny and easy to explain. Investors are taking money out of the euro zone. The European Central Bank reported that non-euro area investors were net sellers of 52 billion euros of member government bonds in the third quarter, having bought 130 billion euros’ worth in the second. German bunds may be the safest European holdings, but as fear mounts they too begin to look unnecessarily risky.
The objective of shunning everything euro related is to stay out of the way of a possible euro collapse. Never mind that the exodus makes that collapse more likely: when investors want out, they run first and ask questions later. And Germany would suffer from a splintering of the euro. While the country would eventually be an economic success with its own currency, a disorderly euro breakup would trash both the financial system and the export business of the zone’s leading creditor and exporter.
European authorities have already missed many opportunities to calm investors down with relatively mild measures. One remaining possible move, resisted so far by Berlin, is for the euro zone to guarantee bonds issued by member nations. Even that would, in theory, dilute Germany’s strong credit a bit. But a disintegration of the euro zone would be far worse. The weak bund auction is a signal for the region’s politicians and central bankers to stop squabbling.
For more independent financial commentary and analysis, visit www.breakingviews.com.
