The devil in the detail of bank stress tests

Fears of finding skeletons in the cupboards of Europe’s biggest banks were swept away last Friday as European regulators announced a 92% pass rate for their eagerly anticipated stress tests.

Let’s face it, this was an anti-climax. Where’s the juice in a 92% pass rate? Spectacular failure is after all a whole lot more entertaining than making the grade.

But on closer inspection it’s what has not been revealed by the tests that proves to be more interesting.

Take, for example, German giant Deutsche Bank announcing on the Tuesday after the release of the results that it did in fact have a whopping €14.8 billion of exposure to the troubled EU states of Greece, Spain, Portugal, Ireland and Italy.

Did they simply forget that they had a potentially lethal exposure to EU periphery states? The mind boggles as to why the bank was not forced to disclose this as part of the stress tests. Surely this is exactly the kind of information that the supposedly stringent tests were designed to elicit?

But then it turns out that this €14.8 billion formed part of the banking book, not its trading book. Well that’s alright then, one switch and €14.8 billion can simply disappear off the balance sheet, just like magic.

Although it faced a barrage of criticism, Deutsche Bank did in fact comply with the rules of the stress tests and was within its rights to withhold information relating to its bank book - we can thank the International Accounting Standards Board for such an agile piece of legislation.

You see in October 2008, in the early throes of the crisis and ‘as a matter of urgency’ as was stated at the time, the IASB, in-step with US policy makers, authorised a change to an accounting rule that allowed banks to choose whether they wanted to hold certain exposure (including sovereign debt) either temporarily or until maturity.

Assets that were held temporarily would form part of the so-called trading book and would need to be marked to market. Whereas assets that were held until maturity made up the bank book and would not need to be marked to market. This effectively allowed many European banks to reclassify their investments and hide huge holes in their balance sheets.

I wonder how many other supposedly healthy banks have made use of this handy little loophole?   

It looks as though it’s a case of the old adage ‘if can’t beat them, join them’ as realistically any bank that chose not to make use of such a useful and more to the point, legal tool would put itself at a disadvantage and therefore not be acting in the best interests of its investors.

Outwardly all parties in this increasingly interwoven story appear to be playing by the rules, but to get to the crux of the issue we have to ask ourselves who created the rules? And why?  

What we then find is that the rule makers are incentivising the use of clever accounting by giving some of Europe’s unhealthiest institutions full marks in the fitness test. In turn, the banks get some breathing space and we investors get to avoid another market meltdown.