Europe’s Bank Assessment: A Worrying Preview From Ireland

The most important thing happening in the European economy over the next year is the ECB’s comprehensive assessment of large euro area banks.  This process will involve an asset quality review, a supervisory risk assessment and a stress test followed by the requirement that banks be recapitalised to address weaknesses that are found.  Yesterday, we got a preview from Ireland as to how this process might work and it wasn’t at all pretty. In fact, it was pretty shambolic.

English: Central Bank of Ireland located on Da...

Central Bank of Ireland located on Dame Street in Dublin. (Photo credit: Wikipedia)

Because Ireland’s banking sector played a major role in sending the country into an EU-IMF program, the troika decided that Ireland’s bank assessment should begin prior to the other countries. So yesterday, the three Irish banks involved in the European bank assessment announced that they had received the results of a “balance sheet assessment” of their accounts of June 2013 from the Central Bank of Ireland (the terminology in relation to the comprehensive assessment changed over the course of the year but this balance sheet assessment appears to be what the ECB now calls an “asset quality review”.)

The timing of these announcements now looks a bit awkward. Originally, the idea seemed to be to have the announcements take place just prior to the ECB’s process for other countries but the timeline on the ECB’s assessment has slipped. It will now review bank balance sheets as of December 31, 2013, so interpreted strictly the Irish banks will need another balance sheet assessment again early next year.  This begs the question why the Central Bank of Ireland (and ECB, who must have been involved) bothered to release the assessment of the June 2013 books at all.

If the timing of the balance sheet assessment was bad, the handling of the announcements was far worse.  As of yet, the Central Bank of Irelandhas made no statement whatsoever on the balance sheet assessments. (Here is its list of press releases.)  Instead, the three banks involved all released their own statements with varying amounts of information disclosed.

Revealing the most information was Bank of Ireland.  This bank released a sheet of information (“Schedule 1”) that looked like something provided to it by the Central Bank of Ireland.  The sheet showed that the Central Bank believed capital was lower and risk-weighted assets higher than the bank’s own accounts showed.

Calculated according to the 2014 regulatory capital rules, the Central Bank believes Bank of Ireland had a common equity tier 1 capital ratio of 9.85% in June while the bank’s own accounting treatment showed a figure of 13.8%.  This 9.8% is still above the 8% ratio that will be required by the ECB following next year’s exercise.  However, it would be below the 10.5% requirement that the Central Bank of Ireland has itself set in recent years.  By this year’s regulatory capital rules, the Central Bank views Bank of Ireland’s common equity tier 1 ratio as 10.6% which is just above this requirement.

Does this mean that Bank of Ireland’s capital ratio is about to be written down by four percentage points? The Central Bank is its regulator so you might imagine that this would be the case.  However, Bank of Ireland’s statement contains a number of criticisms of the Central Bank’s calculations.  Indeed, the bank “remains confident in its own methodologies, calculations and impairment provisions” and the statement merely says the results will “remain subject to ongoing engagement” with the Central Bank.

The Central Bank certainly has the powers to compel Bank of Ireland to raise capital on the basis of its own assessment and this may be what happens.  But it is not clear to me whether Bank of Ireland will be forced to release year-end accounts calculated in line with the methodologies preferred by the Central Bank of Ireland.

All told, it’s hard to know what Bank of Ireland’s reported capital ratios will be in its next report. However, the fact that a stress test has to be done next year and that this exercise will involve further (yet to be determined) capital requirements suggests that the bank will probably need to raise more capital.

If things are a little unclear with respect to Bank of Ireland, the situation is clear as mud when it comes to the other two banks that made announcements yesterday.

Allied Irish Banks (AIB) put out a terse announcement unaccompanied by a Schedule 1 sheet.  It stated

AIB has been advised of the findings of this review which it will consider in the preparation of the bank’s year end December 2013 provisions and financial statements.

Based on an initial assessment of the findings of the BSA, the Bank believes it continues to be well capitalised and in excess of minimum regulatory requirements.

You might be tempted to read that statement and conclude that AIB’s “Schedule 1” sheet showed that it was well-capitalised and did not need to raise new capital. I think that’s a bit optimistic.  AsBill Clinton might say, it depends on what the meaning of “Bank” is.

Given that the “Bank” in question had to do “an initial assessment of the findings” to come up with the “belief” that it is well capitalised, then my interpretation is that the “Bank that believes” is AIB. (The capital B being an affectation the bank (all lower case) likes to use in press releases.)

So the bank (or Bank …) believes that it’s well-capitalised. Well good for them. But remember that Bank of Ireland also disagreed with the Central Bank and believe their own figures are better.  So there’s a lot of subjective beliefs floating around here. Most likely, AIB’s Schedule 1 sheet shows that it requires more capital.

Then there’s the most tight-lipped of the three banks, Permanent TSB, who provided no figures and simply stated

Based on the communicated results the outcome confirms that the capital position of permanent tsb plc is above minimum regulatory requirements.

What this means depends upon whose notion of “minimum regulatory requirements” you’re thinking of.  It could mean above the Central Bank of Ireland’s guidelines of 10.5% or it could mean above the current European CRD4 minimum common equity ratio of 3.5%.  A cynic might suggest that if it was the former then the bank would have released the results. Perhaps modest PTSB (who describe themselves without using a single upper-case letter) are hiding a set of fantastic results. Perhaps not.

The Central Bank of Ireland and the ECB should remember that the purpose of this exercise is to bring clarity to bank balance sheets. Yesterday’s events achieved the exact opposite with people scratching their heads interpreting strangely-worded statements and wondering about the figures that were not reported.

The ECB needs to use yesterday’s events as a lesson. It would not be acceptable for this kind of shambles to be repeated whenever the first stage of the ECB’s comprehensive assessment is completed. Either all banks involved in the process reveal the details of their assessment or else the whole exercise should be conducted in secret.  Allowing stronger banks to report results while we are left wondering about the weaker ones is a recipe for financial instability.

So What’s So Special About Bitcoin?

I received a number of thoughtful comments on yesterday’s article on Bitcoin and wanted to follow up on a couple of important points that they raised and provide some new information.

Some of the pro-Bitcoin enthusiasts were keen to emphasize the difference between Bitcoin and previous potential sources of private money.  It’s digital, so doesn’t have physical production or storage issues and it’s hard to melt down a Bitcoin and pass it off as two Bitcoins, thus perhaps ruling out the role governments played in verifying and securing money in the past.

However, commenters were also keen to emphasize that Bitcoin is special because it can only be created according to a special algorithm that ultimately limits the total number of Bitcoins to 21 million and guarantees that payments are anonymous and irreversible.

The fact that Bitcoin advocates rely so heavily on the niftiness of its underlying algorithms and protocol is one of the best reasons to predict its demise.  If all you have going for you is a cool algorithm, then at some point there will be someone else out there with an even cooler algorithm. And then someone else.

Indeed, there is evidence that this process is already underway. If you don’t want to use Bitcoin, you can always try Litecoin. It promises to be

a peer-to-peer Internet currency that enables instant payments to anyone in the world. It is based on the Bitcoin protocol but differs from Bitcoin in that it can be efficiently mined with consumer-grade hardware. Litecoin provides faster transaction confirmations (2.5 minutes on average) and uses a memory-hard, scrypt-based mining proof-of-work algorithm to target the regular computers and GPUs most people already have. The Litecoin network is scheduled to produce 84 million currency units.

And if you’re in it for the speculation, Litecoin is showing some nice bubbly movements as well.

Or maybe you could go with Primecoin, an

experimental cryptocurrency that introduces the first scientific computing proof-of-work to cryptocurrency technology. Primecoin’s proof-of-work is an innovative design based on searching for prime number chains, providing potential scientific value in addition to minting and security for the network.

Supporting private money and adding scientific value, what’s not to like?

Perhaps though, you are kept awake at night worrying about a 51% attack (no it doesn’t involve aliens or Area 51). In that case, perhaps Peercoin is for you

Peercoin’s major difference from Bitcoin is that it uses a proof-of-stake/proof-of-work hybrid system for coin generation. With this system, coins are generated based on proof-of-stake blocks in addition to proof-of-work blocks. In other words, someone holding 1% of the currency will generate 1% of all proof-of-stake coin blocks.

Proof-of-stake block generation could reduce the risk of 51% attacks ….

This little tour of crypto-currencies (and there’s plenty more) should be enough to convince you that one of these outfits will probably produce a currency that is widely seen as superior to Bitcoin along most dimensions, perhaps attracting lots of supporters on websites and Russian-government-sponsored TV shows.

What happens then to your Bitcoins then?  Even Bitcoin’s own FAQ is clear about the uncertainties surrounding its future.  A brief excerpt:

Can bitcoins become worthless?

Yes. History is littered with currencies that failed and are no longer used, such as the German Mark during the Weimar Republic and, more recently, the Zimbabwean dollar. Although previous currency failures were typically due to hyperinflation of a kind that Bitcoin makes impossible, there is always potential for technical failures, competing currencies, political issues and so on.

So even if private crypto-currencies are the future, that doesn’t mean that Bitcoins will feature in that future. It’s a bit like investing all your money in IBM in the 1970s because you’re sure computers are the next big thing even though you haven’t yet heard of Microsoft or Apple. Or taking a punt on Pets.com in 1999 because the Internet is the future and sure people will still have pets in the future.

The difference in this case is that private currencies are probably not the future.  The very fact that no single private currency can be relied on to have the necessary unique features to become a useful source of value is likely to undermine the whole idea. Like it or not, the US federal government is going to be with us for the foreseeable future, printing dollars, requiring tax payments in those same dollars and enforcing the requirement that creditors must accept dollars as legal tender. Dollars are not going to be dislodged by Bitcoin, Primecoin, Karlcoin or whatever.

Of course, commenters did note another advantage of Bitcoins. They may possibly help to facilitate illegal activities and tax evasion. If that’s why you’re buying Bitcoins, all I can say is good luck with that. Uncle Sam is watching you.

How Is Bitcoin Different From The Dollar?

As Bitcoin goes through another day of crazy price fluctuations and huge publicity, this time courtesy of the U.S. Senate, I recommend two readings for those interested in putting the Bitcoin phenomenon in historical context.

The first is this article by my colleague Stephen Kinsella. Stephen’s key point:

Bitcoin has no use value, only exchange value, and because it is has no worth in use other than what others are willing to pay for it, it is always in a bubble: these happen when prices of assets get dislodged from their fundamental value. So Bitcoin is the perfect bubble.

Now the obvious question that this raises is the following: Is Bitcoin so different from the dollar? A dollar bill also has no use other than what people are willing to pay for it. And if people decide they wish to trust the people who create Bitcoins more than their own government, then perhaps it could be an alternative medium of exchange.

Stephen partially gets at the answer as to why Bitcoin differs from the dollar. It is “a currency not backed by any state – meaning nobody has to take it as payment.” The fact that the U.S. government requires payment in dollars in itself creates a direct demand for dollars that cannot be replicated by Bitcoin.

History shows, however, that the state’s involvement in money goes deeper than merely requiring tax payments in its chosen currency and this history is useful for understanding the likely limits to “private monies” like Bitcoin.

My favorite article on this topic is Two Concepts of Money written in 1998 by legendary British economist Charles Goodhart. I strongly recommend that people interested in Bitcoin read it.

Goodhart argues that states have essentially always been in control of monetary systems. He emphasizes that governments have always viewed seigniorage as a useful form of revenue and are unlikely to allow this source of revenue to be replaced by a private source of money.

Right now, Bitcoins are effectively irrelevant when compared with the larger payments system, but those who anticipate it expanding to be widely used might ask how sure they are that private monies of this type would actually remain private. Once big enough to be termed a success, any such currency would attract more attention from governments than a cursory Senate hearing.

Goodhart also shows the theory that private money can emerge as a solution to the inefficiencies of barter has little historical backing. For example, while people often believe that precious metals were adopted over time by the private sector as a useful medium of exchange, in practice people could not be sure whether the metallic content of coins were equal to stated amounts.

Only when governments standardized and verified such coins – and provided security for mints – were coins widely used as a medium of exchange. Goodhart notes that much of the Roman empire went from a monetary economy back to barter after the empire’s decline. Bitcoin enthusiasts may believe that problems with security and verification are less likely to affect a digital currency. Time will tell us the extent to which that is true.

Advocates of Bitcoin enthuse about its commitment to limiting its supply of virtual coins. Goodhart’s paper discusses whether such commitments from private providers of money can actually be credible. He concludes such commitments probably run against the interest of those who control these currencies and so they should not be trusted. Blind trust in the people behind Bitcoin may turn out to be no more sensible than blind trust in the U.S. government, and quite possibly less so.

There’s no doubt that Bitcoin is an interesting invention, useful at a minimum for provoking good classroom discussions in Money and Banking courses about what exactly is the meaning of money. But people should be wary of investing large amounts of their savings in Bitcoins. History provides plenty of reasons to suspect that private money is unlikely to work. Maybe this time is different. Usually it’s not.

Ireland Exits Bailout With No Backstop: A Good News Story?

After years of turmoil, Europe seems to finally have a good news story. Ireland will be the first of country to exit a “troika” program and yesterday its government announced that it would not even be seeking a “precautionary” credit line from Europe’s bailout fund, the ESM.  But is this quite the good news story that most people think it is? I’m not so sure. Indeed, I suspect yesterday’s announcement illustrates how political problems may undermine Mario Draghi’s plans to save the euro.

There is certainly some good economic news coming from Ireland. Targets laid down in the program for the budget deficit were met and while economic growth has been minimal and unemployment is high, employment is now growing again and a large stock of over €20 billion of cash has been built up via borrowings from financial markets and the troika. By the very low bar set by the recent economic performance of the euro area, Ireland is something of a success.

For these reasons, yesterday’s announcement that Ireland would not need a new bailout was not news. This has been known for some time. The news element here was the announcement that there would be no precautionary credit line. But is that actually good news?

Irish government politicians have been keen to claim that there is some good economic news in this announcement, that it “provides clarity” and “reduces uncertainty”.  In fact, the opposite is the case.

A precautionary credit line is something that doesn’t have to be used. Anything that can be done without a precautionary credit line can also be done with one.  However, without such a credit line, the Irish government run the risk of running out of funds and having to negotiate a new bailout or credit line under far less positive circumstances than currently prevail.  This adds to the uncertainties facing Ireland in the coming year, particularly given the possibility that Irish banks may need further recapitalisation next year.

Ireland’s finance minister, Michael Noonan, acknowledged yesterday that economic conditions may not be so benign next year. This should be seen as an argument for negotiating a credit line now but, strangely, Noonan used this observation as an argument for not seeking a credit line.  He seemed to be struggling to find anything better than weak talking points to explain the benefits of not having a credit line.

There is, of course, a narrow political benefit to the Irish government from this “clean” exit, because it allows them to triumph about the full restoration of “sovereignty.”  However, I don’t think they are so cynical as to have made this decision purely for that populist reason.  Instead, my assessment is that the precautionary credit line could not be arranged now because it was politically impossible and that the Irish government are merely putting a brave face on what is a bad outcome.

The political problem is that credit lines from ESM require the approval of all euro area member states and this was not going to be possible now. Germany still does not have a government as Angela Merkel’s CDU continue negotiations with the SPD to form a coalition. During these negotiations, the SPD has regularly insisted that they would not support an ESM credit line for Ireland unless the country followed a series of highly specific policy recommendations.

SPD requirements for approval of a credit line included raising the corporate tax rate and introducing a financial transaction tax. The SPD also ruled out any deal that involved used funds from the credit line to recapitalize banks.

This kind of micro-managing of other people’s economies was not what most people had expected ESM conditionality to look like. Given the existing raft of EU monitoring programs that exist (the six pack, the two pack, the macroeconomic imbalances) a sensible approach would be to require that a country seeking a credit line from ESM commit itself to meeting the recommendations on macroeconomic policy of the European Commission.

When Germany finally has a government and SPD politicians are firmly ensconced in ministerial Mercs, I suspect the desire to micro-manage Ireland’s affairs will recede. However, the damage may well be done. Having sold the Irish public on the idea that the credit line was something to be avoided, it seems unlikely that the government can change its mind next Spring.

This is the odd aspect of yesterday’s decision. Why not announce that Ireland was exiting the program without a precautionary credit line but that discussions about this issue were ongoing? One unattractive possibility is that Ireland’s leaders were asked by their German colleagues to make this announcement to remove it as an issue in the government formation negotiations.

Missed in yesterday’s discussion is that these developments have implications for the ECB’s Outright Monetary Transactions (OMT) program. This is the program announced by Mario Draghi after his “whatever it takes” speech last year.  Under this program, the ECB can purchase unlimited quantities of a country’s government bonds. However, the ECB decided that countries could only avail of OMT if they had an agreement with ESM for a bailout program or precautionary credit line.

Ask yourself this: If star pupil Ireland couldn’t negotiate a precautionary credit line based on reasonable conditionality, what chance is there that a credit line of this sort for Italy will be approved by all countries in the euro area? OMT may have been cast as the plan to save the euro but getting it up and running may not be so easy.

Resolving Europe’s Banking Crisis

I’m giving a presentation tomorrow afternoon at the annual Dublin Economics Workshop conference in Limerick. (For those of you who don’t know these things, the Dublin Economics Workshop’s annual conference has always been held outside of Dublin ….)

The presentation is titled “Resolving Europe’s Banking Crisis” and provides facts and figures on Europe’s credit crunch, explanations for the sources of this problem and scenarios for the upcoming European banking stress tests.

Ireland’s Blanket Guarantee Supporters: Still Wrong After All These Years

Five years ago, Ireland’s government guaranteed almost all of the debts of six privately-owned banks.  The subsequent bailout of these banks has cost the Irish public over €60 billion with about half of this due to the now-notorious Anglo Irish Bank.

The Cause Of all Our Problems - Anglo Irish Bank

(Photo credit: infomatique)

One might have hoped that those who took the guarantee decision would now express regret. However, politicians from Fianna Fail and the Green Party, the parties then in government, still defend the decision. In continuing this defense, these politicians will undoubtedly now cite the recent article in the Irish Times by former IMF economist Donal Donovan, which claims that the guarantee was the “least worst” (in other words “best”) option available to the government.

Economics can be a tricky business and sometimes the true merits of policies run counter to peoples’ gut feelings. However, if you had thought that a decision to guarantee almost every euro owed by the Irish banks was a reckless one that maximised the subsequent cost to the public, it turns out you’re absolutely right and in this case the contrarian economist is wrong. Donovan’s arguments in favour of the particular guarantee offered by the Irish government ignore widely-understood best practice in crisis management and are based on a flawed understanding of legal issues.

Ireland’s banks were in crisis in September 2008 and there were strong arguments for some form of government intervention to preserve financial stability. Indeed, in the months after the collapse of Lehman Brothers, most European governments offered guarantees of various forms to their banks.

However, with the exception of Denmark, these governments offered guarantees that were far more limited in form than the Irish one.  Specifically, schemes were put in place in the UK, Germany, France, Italy and elsewhere that guaranteed only new bond issues. (See this ECB report for a detailed description). This approach dealt with the problem at hand (banks having difficulties in getting funding) without making the public responsible for the full stock of debt that had been accumulated by their banks.

Most likely, other European governments were aware of the dangers of blanket guarantees. Research from the World Bank and the IMF had repeatedly demonstrated that guarantees of this type resulted in a substantial increase in the costs of banking crises.

While the “new debt only” approach to guarantees was adopted throughout the rest of Europe, it is dismissed out of hand by Donal Donovan who argues that the need to provide guarantees for new funding when existing debt subsequently fell due would have led to the government guaranteeing the same amount of money.   This ignores the reality that the Irish banks had plenty of “locked-in” long-term funding that could not have be pulled at short notice.  For example, as of September 2008, Anglo had €38 billion in liabilities with a maturity over three months (see its annual report).

Even after passing the guarantee, the Irish government knew within three months that Anglo was a rogue institution. So a “new funding only” guarantee would have allowed the government to apply well-understood resolution tools for closing Anglo. Retail deposits (which accounted for less than twenty percent of Anglo’s liabilities) could have been moved on to a new institution and the remaining “bad bank” could have been put into liquidation with unguaranteed creditors taking losses on their investments.

Those who argue that such a resolution would not have been possible should remember that both events have now occurred. Anglo’s deposits were moved to AIB in 2011 and the rest of the bank was put into liquidation this year.  Unfortunately, these actions were taken long after public money had been used to fill almost all the hole in Anglo’s balance sheet. I don’t wish to argue that an earlier application of these resolution tools would have been costless for the Irish public but they would have substantially reduced the burden on the public while maintaining financial stability.

Donovan’s article repeats an argument often rolled out by the last government to defend the form of the guarantee, which is that Irish law would not have allowed for a selective guarantee that covered some liabilities but not senior bonds.

This argument is based on a flawed understanding of debt contracts and the legal basis for guarantees. Contractual clauses for senior bonds that state that they rank equally with other liabilities are only operable in a liquidation. Independent of the outcome of any liquidation, governments are free to provide additional insurance to whichever creditors they choose. If Donovan’s argument was correct, then deposit insurance would be illegal because governments could not single out this class of creditors for special protection. In reality, no such prohibition exists.

The fact that the ECB used their influence in 2010 to convince the Irish government to continue repaying unguaranteed debt is cited by Donovan as a further argument that the blanket guarantee was unavoidable. However, these discussions took place after the Irish government had taken on all of Anglo’s debts which over time became debts to the ECB.  This gave the ECB enormous power over the Irish government in 2010. A limited guarantee in 2008 followed by a quick resolution and liquidation of Anglo would have kept the Irish government out of this precarious situation in the first place.

The final excuse offered for the blanket guarantee – that the government believed the banks had a liquidity problem but not a solvency problem – also lacks merit.

A liquidity problem did not require the guaranteeing of locked-in debts and, in any case, the evidence that the banks were heading towards a serious solvency problem was all around us by September 2008.  Brian Lenihan had already admitted the construction sector had come to a shuddering halt and warnings from economists and journalists such as Morgan Kelly, Alan Ahearne and Richard Curran should have given pause for thought before placing the debts of the banks on the public’s shoulders.

People are perhaps understandably tired at this point of again debating the merits of what happened five years ago. However, the additional debt piled on the public by the guarantee will make a big difference to ordinary Irish people’s lives in the coming years, forcing more fiscal adjustment than would be necessary if there was a lower level of debt.   And Ireland’s issues with problem banks are not necessarily a thing of the past.  A country that won’t learn from its mistakes will be condemned to make them again.

Fianna Fail may well be back in government in Ireland in a couple of years and their continued defence of the blanket guarantee policy increases the chances that such a guarantee could be put in place again.  Donal Donovan’s arguments, however well-meant they may be, do not provide reasonable justification for an approach to banking problems that is unsound, unfair and unnecessarily expensive for the public.

Mr Draghi, The Vicious Circle And The Stress Tests

I was in Brussels on Monday and attended the European Parliament’s Economic and Monetary Affairs Committee for its latest meeting with Mario Draghi. The main topic of the meeting was the ECB’s new job as supervisor of the euro area’s banks. I came away from the meeting very concerned about two issues: The effect of banking problems on sovereign debt and the credibility of the upcoming stress tests.

Mario Draghi, President of the European Centra...

Mario Draghi, President of the European Central Bank. (Image credit: AFP/Getty Images via @daylife)

The Vicious Circle

The decision to allocate the ECB the task of single supervisor for banks stems from the June 2012 meeting of euro area leaders which declared “We affirm that it is imperative to break the vicious circle between banks and sovereigns.”  It was also agreed at that meeting that the euro area’s bailout fund, the European Stabilisation Mechanism (ESM) could be used to recapitalize banks that were in difficulty. For many at the time (including me) this statement was an important positive step.

Because Europe’s leaders would not agree to money being provided to banks in other countries without assurances that these investments had solved problems and could guarantee a return for taxpayers, it became politically imperative that there be a pan-euro-area supervisor of banks that could be relied on to provide an independent assessment.

The ECB has been chosen to do this supervisory job and its first task will be to undertake an assessment next year of the health of the approximately 130 banks that it is to directly supervise. Details on the upcoming assessment process are sketchy at this point other than that it will contain an asset quality review, a balance sheet assessment and stress tests run in conjunction with the European Banking Authority.

MEPs at Monday’s meeting repeatedly questioned Mister Draghi about what would happen if a bank failed the upcoming assessment and needed a large injection of capital. One potential answer was that the proposed new Single Resolution Mechanism, effectively a form of European FDIC, would provide the funds.  However, this mechanism won’t come in to place until 2015 and when it does it won’t have any money: As with the FDIC, it is to be funded over time via contributions to banks.  In the future, the Resolution Fund could borrow from the ESM but it is unclear if this could ever actually happen and highly unlikely that plans will change to see the Resolution Fund swing into action next year.

Instead, Mister Draghi repeatedly emphasized that “national backstops” were the key mechanism for dealing with banks that needed more funds (see reporting here and here.)  This shows how little progress has been made in breaking the vicious circle referred to in last year’s summit statement.

The euro area’s leaders have agreed to a grand plan under which at some point in the fairly distant future, the cost of dealing with bank failures won’t fall directly on the taxpayers unfortunate enough to reside in the same country as the bank. However, for now, Draghi’s comments ensure that national taxpayers remain first in the firing line when banks fail. In this sense, the current vicious circle that actually prompted the June 2012 summit has gone from something that it is “imperative” to remove to something that is effectively official European policy.

Credibility of Stress Tests

The continued reliance on “national backstops” seems likely to affect the credibility of the upcoming stress tests. ECB officials have repeatedly criticised the previous stress tests undertaken by the European Banking Authority for their lack of credibility. Implicit behind this criticism is the assumption that the ECB tests will be tougher, with more negative valuations for bank loans in arrears or other distressed assets.

Draghi’s statements about national backstops, however, undermine the credibility of the new exercise before it has even started. He insisted on Monday that it is realistic for national backstops to be used to sort out banking problems, even in countries like Spain or Greece. Given the perceived size of banking problems in these countries as well as existing levels of public debt, this is effectively an early signal that the new stress tests will not uncover many problems.

The balance sheet assessments will feature many outside advisors who will provide technical expertise in coming up with figures for capital shortfalls. This is a lucrative business and consultants who wish to be re-hired have an incentive to give the answer the client wants. Draghi waxed lyrically on Monday about how

One of the outcomes we expect from these tests is to dispel this fog that lies over bank balance sheets in the euro area

and expressed confidence that the condition of Europe’s banks was improving. This happy message will be taken on board by the outside consultants.

The hiring of Oliver Wyman as the ECB’s own consultant doesn’t do much to boost the credibility of the upcoming assessments. Leaving aside their infamous award to Anglo Irish Bank as the world’s best bank in 2006, this firm carried out stress tests on Spanish banks last year coming up with a €60 billion recapitalisation figure that few consider credible. (For comparison, the Irish state coughed up €64 billion for its banks — Ireland is a lot smaller than Spain and Spanish house prices are still falling.)

Of course, it’s also possible that the bank assessments will be realistically tough and, where public funds cannot be used, the ESM could be called on to provide money for recapitalization. However, the €60 billion currently earmarked for potential use by ESM is a small figure relative to the size of Europe’s bad bank assets and, even then, it seems unlikely that Germany, Finland and the Netherlands will budge from their position that ESM cannot be used to replace losses on “legacy assets.”

A final scenario consistent with the possibility of tough stress tests is that, where national governments don’t have the funds, there will be significant bail-in of bank creditors with bondholders and possibly depositors losing out. Given the chaotic implementation of the Cyprus bail-in and the lack of progress on resolution authority, I seriously doubt that the European institutions have the capacity to execute a simultaneous multi-country programme of bank bail-ins while maintaining financial stability.

That leaves the path of least resistance: Weak stress tests that see the vast majority of banks pass and the problems with bank assets continue to be largely ignored.  With so many new institutions in place, perhaps a gentle run-through was the best that could have been expected from this exercise in any case, with more serious tests reserved for down the road when the banks are in better condition and disagreements about resolution have been settled.

In the meantime, Europe’s weak banks are likely to continue in their zombie state, squeezing credit to firms and households and holding back the recovery that Europe so desperately needs.