Trying to prop up confidence by hook or crook.

By Don Quijones, Spain & Mexico, editor at WOLF STREET.

Things have been pretty stressful of late in Europe’s banking sector. The introduction of the banking union’s bail-in rule has caused bondholders and stockholders to have second thoughts. The Euro Stoxx Banks Index has plunged 20% year-to-date despite the recent rally, and is down 38% since July.

Many of the worst affected bank stocks are those of so-called systemically important institutions. Deutsche Bank’s shares are down 50% from highs last July, while Spanish behemoth Santander’s shares have plumbed depths not seen since the 1990s. Concerns have also emerged about the ability of big lenders to turn a profit in a negative-interest-rate environment, following disappointing earnings by Societe Generale SA, HSBC Holdings Plc and Standard Chartered Plc.

In recent years, TBTF institutions like HSBC, Santander, Societe Generale and Deutsche have become so hideously big, complex and interconnected that it’s impossible to get an accurate impression of what’s really happening on and off their books. It is supposedly for this reason that the world’s two biggest central banks – the Fed and the ECB – began conducting regular stress tests of the financial sector to gauge just how effectively such banks would withstand a severe deterioration of macroeconomic conditions.

In the Fed’s last stress test, in May 2015, only two banks out of 31 failed to meet the grade: the U.S. units of Deutsche and Santander. One thing that is clear: European banks remain woefully under-capitalized compared to their U.S. counterparts.

Santander’s failure, its second in two years of taking the test, “was a clear signal that it hasn’t made enough progress on the issues the Fed had identified the previous year,” the Wall Street Journal reported at the time. Santander’s US chief executive, Scott Powell, said the bank still had “meaningful work to do to meet our regulator’s expectations and our own standards of excellence”.

Judging by an article just published in El Confidencial, the bank still has a long way to go:

Although officially speaking the U.S. banking supervisor still hasn’t published the findings of its Comprehensive Capital Analysis Review (CCAR)… at Santander’s headquarters in Boadilla del Monte it’s already taken as a given that it will have to wait at least another year before passing the stress test.

In light of Deutsche’s recent Co-Co fiasco in Germany, one assumes that the bank is in the same leaky boat. Which begs the question: with banking risk surging and investor confidence crumbling, how exactly will the ECB’s European Banking Authority be able to conduct its own rigorous (ha!) stress tests of large European banks without setting off further alarm bells and creating even more stress in the markets?

The answer is quite ingenious.

The London-based EBA will intentionally ignore many of the worst stress points in the system while conducting a test that not a single bank will be able to pass or fail. The reason the test has no pass mark to identify capital shortfalls is that banks have apparently emerged from the financial crisis. No, seriously. In the words of the EBA, they are in a “steady state” and are therefore expected to remain that way.

Among the severe stress points the supervisor has said it will be paying no attention to are the four biggest banks in Greece, a country that only eight months ago was in the grip of one of the worst bank runs of living memory. According to Danièle Nouy, the Chair of the ECB’s Supervisory Board, there’s no need to assess the resilience of Greece’s biggest banks because they “already went through a stress test in 2015.” The supervisor will also be ignoring Portugal’s Novo Banco, the so-called good bank recently salvaged from the smoldering ruins of Banco Espíritu Santo.

The “Adverse Scenario” for this year’s health check, published by the EBA, exposes banks to recessions in the EU this year and next followed by anemic growth in 2018. It also assumes continued low oil and commodity prices and GDP rising by only 3.4% in China this year, compared with a baseline projection of 6.5%. In Russia and Brazil, 2016 GDP plummets 8.1% and 5.9%, respectively.

It sounds disturbingly similar to today’s reality, with one glaring omission: the EBA’s test completely overlooks the threat posed by negative interest rates. As Reuters reports, negative interest rates — seen as one of the biggest obstacles to banks making money — feature only among the shocks to assets held in trading books, and not to overall balance sheets. The reason? “To avoid shaping expectations of future monetary policy.”

A financial stress test is only as good as the scenarios on which it is based. In its latest test the scenario cooked up by the EBA not only fails to reflect the risks posed by a likely future reality, it doesn’t even reflect the risks posed by the current one.

Ever since it began conducting its annual stress tests in 2009, the EBA has spectacularly failed to restore trust in Europe’s broken banks. Many of the Continent’s worst banking failures, including Bankia BFA and Dexia, happened after the banks had passed the stress tests – sometimes weeks earlier.

Now, as Europe’s financial edifice once again totters on its flimsy foundations, the ECB has set a test that not a single bank is able to fail. This is supposed to inspire confidence, because confidence is the name of the game in banking. However, setting the standards this low is unlikely to inspire confidence. Instead, it reeks of desperation. By Don Quijones, Raging Bull-Shit.

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