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10 MAY 2011

European Bank Crisis and Stress Tests

Last summer's stress tests were meant to restore confidence in banks. This was Europe's attempt to tell global markets to 'calm down, dear' . It failed. Nineteen weeks later, the Irish banks collapsed and taxpayers across Europe were forced into a bail-out, and just last week we learnt that EUR 12 billion of the proposed Portuguese bail-out is for their banks.

The sovereign debt crisis will not be solved until the bank crisis is solved – and the bank crisis will not be solved until markets are confident in providing capital and liquidity to banks.

Stress tests are meant to stress risks. To assuage market concerns they must stress the risks that the markets are concerned about, and right now the markets are concerned about sovereign debt levels. Refusing to test the sovereign debt held on the whole bank balance sheet will not restore confidence.

The European Banking Authority is of course caught between a rock and a hard place: publicly admitting that the risk of a write-down exists may perpetuate the risk of it occurring, but denying that it exists at all would be downright irresponsible for a regulator.

And then there are the trillion dollar questions. Behind closed doors the argument has focused on the numerator. What type of capital do banks hold? The longer individual countries fight for their own opt-outs, the more everyone becomes aware that not all banks are equal and market concerns multiply. But we should also be concerned about the denominator.

What is the risk of the assets on the balance sheets, and can you trust the risk weights applied to those assets? If US banks have risk weights 50% higher than European counterparts, are Europe's banks being allowed to fundamentally misrepresent the risks on their balance sheets?

The financial crisis should have taught us all to value transparency. For depositors, investors, borrowers and taxpayers these stress tests do not offer transparency and that is a travesty.

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