The ECB’s stress test is a positive – but only first – step
Stress testing is performed in a number of arenas. Tools and parts are stressed to ensure that they will stand up to extreme conditions. Medical patients are stressed to detect heart disease. Computer systems are stressed to ensure that they can operate stably at peak times.
In 2009, American banks became the subject of stress tests. For both regulators and firms, this was an appropriately named endeavor. Nonetheless, the exercise helped stabilize the U.S. banking system after the financial crisis, and legislators consequently saw fit to include regular testing for large banks in the Dodd-Frank Act.
The eurozone was eager to import the stress-testing model, but its early adaptations were incomplete and not fully credible. Last Sunday, the European Central Bank (ECB) released the results of its comprehensive assessment (CA), a more rigorous analysis of the Continent’s banks. The ECB’s work was ambitious, covering four times the number of banks included in the Federal Reserve’s annual review.
The project had two stages: the first was an asset quality review (AQR), which reviewed balance sheet assets to determine whether they had been properly evaluated by the banks (and their local supervisors). The AQR also set a strong starting point for the second phase of the effort, which was a stress test.
Prior attempts of this kind in Europe were criticized for not being sufficiently harsh. But on the surface, the results of the CA seemed rigorous, and Europe’s banks issued lots of capital in anticipation of their release. 
The headlines following the publication of outcomes have focused on the relatively small number of banks that must raise more capital. Although 24 of the 130 banks covered “failed” the CA, this was based on end-2013 data. Since then, 12 of the banks have added a combined €56 billion to their capital, leaving just 13 institutions still facing shortfalls.
Investors were relieved that there were no nasty surprises, particularly among the largest institutions, and markets shrugged off the weaknesses of the Italian banks, four of which have to raise a combined €3.3 billion. Investors also seem pleased with the enhanced level of transparency brought to Europe’s banks, with more than 1,000 data points now available for each of them. But before concluding that all is well, several things bear noting:
- The findings concluded that the banks had overvalued their combined assets by €48 billion. More important, the AQR also revalued €136 billion in assets as non-performing loans. These are sizeable numbers that raise questions about the judgment of banks and their national regulators.
- The scenario the stress test used might not have been the most stressful. Macro and market variables were not projected to decline by nearly as much they are in the Federal Reserve’s capital reviews. Further, the scenario the ECB used did not include any deflation, which many analysts think could occur if the eurozone returns to recession.
- The exercise was based on existing definitions of capital adequacy, not the more- stringent Basle III standards that will be phased in over the next few years. Under “fully loaded” Basle III, 11 additional institutions would have “failed” the assessment, with many others passing by only the thinnest of margins. Many banks in Europe also have very low leverage ratios, the simple comparison of capital to assets that removes the influence of bank risk models.
Taken together, this implies that Europe’s banks – particularly those in the eurozone – will need to continue improving the quality of their capital for some time to come.
Starting next month, the ECB takes over regulatory authority for the 123 largest eurozone institutions – and the CA covered about 82% of those assets. This is the next and crucial step toward creation of a eurozone-wide Bank Resolution Fund, which is scheduled to be initiated in 2016. The approval of the contributing countries will be required, though, and this might not be the easiest task.
National regulators will continue to oversee smaller banks across the Continent. This is notable because the credit crunch that has assailed Europe since 2008 has hit small- and medium-sized enterprises (SMEs) particularly hard; SMEs are often financed by smaller, regional institutions that tend to have strong ties with local political interests.
All told, the comprehensive assessment was a very important step. It undoubtedly encouraged a number of institutions to strengthen their capital bases. The application of unified asset quality rules will certainly make it easier to compare institutions and sectors, and it was a key milestone in the long journey toward a eurozone-wide banking system.
But the lack of credit growth across Europe is as much, if not more, a function of demand. Public and private sectors are heavily indebted; corporations and households are still busy deleveraging; and we are probably starting to see demographic changes weigh on the willingness to borrow. So while one source of Europe’s stress may have eased, many others remain.
Declining Oil Prices: The Gain and the Pain
Earlier this year, there was some speculation that high oil prices might be headed higher in reaction to mounting geopolitical tensions. But surprisingly, oil prices tumbled from around $115 a barrel in mid-June to around $85 a barrel today. At the current oil price range, there are winners and losers. For the United States, the world’s largest oil producer and consumer, lower oil prices are a mixed bag.
Gasoline and other motor fuel purchases in total U.S. consumption expenditures amounted to roughly $250 billion in 2013, after adjusting for inflation. Although the percentage drop in gasoline outlays likely will be substantially smaller than the 25% decline in the oil price, the bottom line is that household budgets have more dollars for discretionary spending. Since consumption accounts for nearly 70% of American gross domestic product (GDP), this should give an extra boost to growth in the quarters ahead.
But there are others who stand to lose. Drilling for oil will be less viable if oil prices do not stabilize. Oil prices have held around $100 per barrel since early 2011, the longest period of such elevated prices. Persistently high oil prices aided the economics of new technological developments, which ultimately resulted in a nearly 50% increase in oil production during 2006-2013.
There are a number of estimates of the oil price that would make production unsustainable. A recently publishedlist from Reuters places the breakeven price in the $70-$80 per barrel range. Shale oil, the primary reason for the jump in oil production, is likely to suffer if oil prices decline below this range.
Oil firms have hedged against low oil prices, but the extent is unclear. Recent earnings reports of oil companies are mixed. The obvious question that follows is how investment in the oil industry will fare in the quarters ahead if profits decline and oil prices fail to stabilize.
Investment in oil and gas structures and equipment summed to about $150 billion during third quarter of 2014 after adjusting for inflation, which is close to 1% of U.S. GDP and about 7% of business investment. Growth in this sector was strong during 2010-12, but it slowed thereafter.
It is within reason to conclude that the unfavorable price environment is not supportive of an acceleration of investment in this sector. The projected weakness of growth across the global economy, excluding the United States and United Kingdom, introduced an element of pessimism to the crude oil market. Until this sentiment turns, investment in oil and gas exploration in the United States can be expected to moderate.
The United States is the second-largest importer of crude oil. Imports of petroleum products are likely to decline to 3.2 billion barrels in 2014 from a peak of 5 billion barrels in 2005. The large reduction in oil imports has helped to narrow the trade deficit and lift real GDP.
From an employment perspective, payroll employment in the oil and gas industry has expanded sharply in the past five years, showing a gain of about 60,000 jobs. While lower oil prices could dent the momentum, this represents a small fraction of the total number of jobs created during the five years of economic expansion.
In sum, the net impact of lower oil prices for the United States is probably positive. But there are entries on both sides of the ledger. That represents a huge change from a generation ago.
Outbreak
The Ebola virus has spread rapidly through West Africa and even more rapidly in the world’s consciousness. While we should be most concerned about the terrible human toll of the outbreak, the economic toll is rising as well.
For the countries where infection has been most prevalent, normal patterns of commerce have been substantially interrupted. Many people have been confined to their homes because of fear or fiat. Supply chains have frayed. Public and private resources have been diverted to fight the epidemic. Tourism is well down.
Developing countries in West Africa have received some increased attention in recent years for more favorable reasons. Many are resource-rich and have consequently attracted substantial foreign investment. Populations in the region are growing rapidly, leading some to predict that these “frontier markets” may drive world growth in the decades ahead. The current epidemic will put a damper on such enthusiasm.
Outside of the most affected areas, Ebola has gone viral in people’s perceptions. While there has been only a handful of cases in the United States, fear of infection has spread far more quickly. Some travelers in the Dallas airport have sported surgical masks, even though the virus cannot be contracted by inhaling air. Domestic airline bookings are off from normal seasonal patterns. Governors are calling for broad quarantines. As the headlines accumulate, so does the anxiety, which is not what retailers need going into the holiday season. 
And while many factors have contributed to the market’s volatility, Ebola is frequently cited as another brick in the rising wall of worry that faced investors earlier this month.
The World Bank estimates that about 80% of the economic costs of the Severe Acute Respiratory Syndrome (SARS) outbreak of 2003 and the bird flu outbreak of 2005 resulted from behavioral impacts, not the direct expenses of dealing with the disease. Ebola has already infected and killed more people than either of those two, so the potential for economic impacts could be far greater. A cure for the ailment, physically and mentally, would be most welcome.
The opinions expressed herein are those of the author and do not necessarily represent the views of The Northern Trust Company. The Northern Trust Company does not warrant the accuracy or completeness of information contained herein, such information is subject to change and is not intended to influence your investment decisions.
