THE BLOG
07/26/2010 02:48 pm ET Updated May 25, 2011

European Bank Stress Tests are Tragic-Comedic Farce

When the Obama Administration assumed office in early January 2009, the President's chosen Secretary of the Treasury, Timothy Geithner, was already on record as estimating that the United States banking sector was in such dire straits resulting from the global financial and economic crisis triggered by the collapse of leading investment banks on Wall Street, it would require $2 trillion in government bailouts to repair the damage.

However, once in power, President Obama and Secretary Geithner were reluctant to ask American taxpayers for another handout for Wall Street after the highly unpopular $700 billion TARP bailout. Their response was to rig a series of so-called banking stress tests, which were completed in the spring of 2009.

Only months after the near implosion of the global financial system, Geithner's stress tests supposedly showed that the U.S. banks were in such excellent shape, only a handful required a measly $75 billion in recapitalization, a sum that could be easily raised through private investors. Never mind that Geithner's stress tests incorporated "worst case" unemployment rates that were already eclipsed by the summer of 2009 and other less-than-rigid assumptions. The market seemed to be charmed by Geithner's charade, attested to by rising equity values of financial firms. Now the Europeans hope they can pull off the same performance.

With much fanfare, the Committee of European Banking Supervisors has announced the results of their own engineered bank stress tests, involving 91 banking institutions in 20 European countries. The architects of this banking Eurofest knew they could not show that all 91 had "passed" the stress tests, as this would simply not be credible even to the most gullible.

For that reason, seven banks were selected as sacrificial lambs, and revealed as having failed the stress test, including five relatively minor Spanish banks, as well as the much larger state-owned German property and municipal funding specialist, Hypo Real Estate. This latter financial institution was so heavily weighted with toxic real estate assets, providing it with a passing grade would clearly have given the game away. However, despite the not unclever manipulation engaged in by the Committee of European Banking Supervisors, a growing number of observers and investors have begun to see through this farcical exercise.

Consider this; how valid can a stress test of European banks saturated with government bonds and other long-term public debt instruments really be if the supposed "worst case scenario" envisions no possibility of sovereign debt default in Europe? Only months after Greece was on the verge of public debt default without a massive Eurozone financial bailout, in turn funded by European countries that are themselves becoming increasingly mired in a profound sovereign debt crisis? Neither did the tests consider the possibility of a real estate or commodities crash, despite warnings that, among other dire possibilities, a global commercial real estate crash is increasingly likely.

The authors of this banking stress test would have one believe that not a single UK bank is in danger from worsening economic developments, despite a warning issued by analysts at the Royal Bank of Scotland to senior British policymakers in January 2009, entitled "Living on a Prayer," which stated that almost the entire banking sector of the United Kingdom was "technically insolvent."

In February 2009, the European Union's own executive branch, the European Commission, issued a confidential report, subsequently leaked to the British newspaper, the Daily Telegraph, which warned that European banks collectively held as much as 18.6 trillion euros in toxic assets.

In the past 18 months we have witnessed a massive expansion of public debt across Europe to fund economic stimulus programs, which has produced at best anemic or stagnant growth figures, at the price of catastrophic levels of sovereign debt, prompting these same countries to now reverse fiscal policy and revert to budget trimming austerity measures. The likely outcome is clear; a double-dip recession in Europe, in conjunction with a lack of financial capacity by European taxpayers to again bail out their banking system to the same profligate degree that was undertaken after the collapse of Lehman Brothers.

As with Timothy Geithner, the architects of the European banking stress tests hope that investors and the general public will believe their farce, based on totally unrealistic and overly-optimistic scenarios. In the case of Europe, the fervent desire is that the banks which are rightfully worried about counter-party risk will jettison their well-founded anxieties, and resume interbank-lending and credit flows at pre-crisis levels. However, as the American experience reveals, a banking stress test based on public relations requirements rather than realistic financial and economic modeling may boost the stock price of major banks, justifying massive bonus payments to banking executives. However, as a solution for the continuing credit crunch and economic turmoil, it is no more than a tragic-comedic farce designed by committee.