How has the European Central Bank Stress Tests Impacted the Euro

How has the European Central Bank Stress Tests Impacted the Euro. The EuroZone has traveled a very peculiar path since the eruption of the 2008 Global Credit Crisis.  When the Crisis first occurred, most of the attention was on the United States as it became evident that a huge sub-prime housing bubble had burst.  Then, quickly, it became apparent that the rest of the world was also in trouble.  The beginning of the Crisis was borderline hysteria as global equity and forex market unraveled and many thought a Financial Armageddon was upon us.  But just as the hysteria was reaching scary levels, world leaders came together in unprecedented fashion and agreed to provide liquidity to the inter-bank market.  Eventually equity markets bottomed out in March of 2009 and the world economy began its march upward back to levels of consistent growth.

Beginning in the Spring of 2009, it became clear the EuroZone had handled the Credit Crisis extremely well.  The European Central Bank had appeared to weather the storm much better than the U.S.  So much better, in fact, that talks began to be heard of the Euro possibly replacing the U.S. Dollar as the world reserve currency.  The Euro began to take its place as the world’s most beloved currency.  The European Central Bank had pumped much less stimulus into the market than the United States, and it looked as though the EuroZone had positioned itself very well for the future.

And then after nearly 6 months of strong EuroZone growth and a big rally in the Euro, it became apparent that several EuroZone countries were in danger of sovereign default.  This threat began to grab headlines in November of 2009, and the Euro began its precipitous decline the next month, in the beginning of December.  As the Greek Debt Crisis grew, it became apparent several member countries were in serious fiscal trouble including Spain, Portugal, Italy, and Ireland.  Eventually, after much discussion, the European Central Bank finally decided to provide liquidity in the form of a bailout for any member countries that needed it.  This settled markets down and brought support to the Euro.  At least temporarily.



The possibility of sovereign default is still present among weak EuroZone countries, and no one is sure how much of an effect a default would have on the global financial system.  So, to ease investor fears and bring more confidence to credit markets, the ECB has decided to follow in the footsteps of the U.S. and subject 94 banks throughout the EuroZone to a stress test.  Basically, the stress test will create a simulated financial meltdown in order to determine how well each bank could hold up.  The problem is that the ECB is being very vague and ambiguous concerning what exactly the stress test will entail.  Investors are worried that the test will not truly test the banks’ ability to handle an all-out default by countries such as Greece. 

The main concern investors have at the moment is that the test will not truly assess banks, but the results will be published as if they did.  Then, when sovereign default really hits, a different scenario, a much uglier one, would actually play out.  Current unconfirmed reports say that in the stress test, banks will have to take suffer a 17% markdown of all Greek debt they are holding.  But what if in actuality, the markdown is much more?  How would banks be able to handle such a threat?  These are the questions that remain unanswered.  When asked for more clarity concerning the details of the stress test, ECB President Jean-Claude Trichet has been extremely ambiguous.  At the moment, the Euro is having a difficult time moving to higher levels, and this lack of investor confidence in the European Bank Stress Tests is one of the primary reasons the Euro is running into a bit of resistance.

When the U.S. conducted its stress tests on financial institutions the dynamic was much different than the one Trichet and his team has to deal with.  In the U.S., all banks are, of course, under U.S. law and under the same federal laws.  In the EuroZone it is much more complicated because of the diversity of each member country.  This fact in itself makes investors scared concerning how the EuroZone would handle a potential banking crisis.  When you are dealing with hundreds of major banking institutions in over a dozen different countries with a dozen different legal systems, it gets much more difficult for banks to be willing to lend to one another, which is absolutely essential during times of economic distress.  If banks stop lending to one another, the liquidity dries up in the interbank market and the economy can literally collapse.  This fear is a possibility in the European banking system, and if it materializes, the Euro could see a rapid decline.