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Thursday, January 16, 2014 3:17 PM

ECB Waters Down 2014 Stress Tests Second Time; Yet Another Sham Stress Test

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Bloomberg reports ECB Said to Favor 6% Capital Requirement in Stress Test when it puts them through a simulated recession later this year, said two euro-area officials.

Strict Rules Revisited

With a hat tip to ZeroHedge, let's flash back to an October 23 Bloomberg report: ECB Capital Definition Tougher in Stress Test Than Review

The European Central Bank said it will use stricter rules when stress testing banks’ balance sheets next year than it will to study their assets, as it seeks to prove its credentials as the region’s financial supervisor.

While the ECB confirmed that it will require lenders to have a capital ratio of 8 percent, what qualifies as capital will change over the course of the three-part assessment, the central bank said in an e-mailed statement.

Ignazio Angeloni, who is head of the ECB’s financial stability directorate, said in Frankfurt “We’ve got a feasible but safe capital cushion of 8 percent. We want the exercise to encompass all the main sources of risk.
What About Sovereign Bonds?

Are Sovereign bonds a major source of risk? One would think so. At least one should think so.

Yet, just today, the ECB whitewashed sovereign bonds as a no risk item.

Via translation from El Economista please consider Most of the public debt held by banks not penalized in the stress test.
What looked like was going to be a strict stance of the European Central Bank (ECB) regarding sovereign debt portfolios of financial institutions, is not so.

Until now it was expected that institution had to rate all sovereign bonds "according to the risk they pose to the banks' capital." Given that requirement, banks could be forced to provision capital against potential risks from the exposure.

But now ECB president Mario Draghi, says debt that banks hold to maturity will not have to be set at market value or penalized.

"The ECB will not force European banks to adjust to market value of sovereign debt portfolios that are classified as held to maturity. However, we will penalize banking exposure to bonds contained in the trading book, i.e., those that are available for immediate sale."
Another Sham Stress Test

As a result of that preposterous trading-book rule, banks will shift 100% of their sovereign bonds to their hold-to-maturity bucket, at least for the duration of the test.

Thus, not only have we seen a 25% reduction in capital that banks have to hold, effectively all sovereign bonds are deemed to be risk-free for the test.

Listen to what Ignazio Angeloni, head of the ECB’s financial stability directorate says today: “At first sight the 6 percent target looks manageable and less ambitious than what people might have expected. However, given Draghi has been very explicit in willing to carry a tough and credible stress test, this might also imply that the macro adverse scenario the ECB will apply will be much more severe than what the EBA did last time.

Angeloni Translated: "At first glance it appears we watered down the stress tests. And we did do just that. However, the tests are still credible, because we say they are".

Recall what Mario Draghi said in October. "Banks do need to fail to prove the credibility of the exercise. If they do have to fail, they have to fail. There’s no question about that."

Draghi Translated: "If banks have to fail, they have to fail. However, our mission is to make sure the stress tests are weak enough so that no banks fail or only a token number of hand-picked banks fail. We have not yet decided on the number, but we can guarantee you, it won't be big."

Mike "Mish" Shedlock

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