Friday, October 28, 2011

Being pessimistic to build optimism

The new European plan to deal with the potential of sovereign default and the increasing doubts about solvency of financial institutions was announced two days ago. Financial markets so far seem to like the plan. The plan did not provide many surprises, it was very much what was expected. Maybe the surprise, to some, is that there was an agreement on the plan.

One issue that was debated in the preparation of the plan is how to account for potential losses derived from default on sovereign debt when doing stress tests on banks.

But here is a problem: European governments want to send two messages:

1. No default will ever take place in Italy or Spain.
2. Financial institutions are safe, they have enough capital.

But how do you build a capital buffer for banks that convinces markets? By being pessimistic and consider scenarios where things really go wrong. When doing this exercise there is a big difference between losses on sovereign debt and losses on other loans. For other loans one can imagine different macroeconomic scenarios where housing prices or GDP are more or less affected and this leads to a certain % of loans going bad. The disagreement can be on how pessimistic you want to be but conceptually we all understand how the different scenarios are being built.

When it comes to sovereign debt, there is something much more problematic. Will governments default? According to market prices there is a significant probability of default by several European governments. According to European governments this will never happen. But we heard that before about Greece...

In the current situation, whom you believe is going to determine the fate of some of these governments. If market participants believe Italy or Spain will default then their interest rates will keep increasing and those two governments will not be able to sustain their current debt levels. But if there is trust and interest rates remain low, they have a higher chance of surviving. Expectations are key and both outcomes are possible. If we all become pessimistic we end up in a self-fulfilling crisis.

Being pessimistic when doing stress tests on financial institutions is a way to generate confidence. We build a capital buffer that is large enough to deal with any possible crisis. But if you send a pessimistic message about sovereign debt then you cannot achieve the first goal! How do you strike a balance?  This is what the Europeans have done: they have built a capital buffer to deal with potential loses derived from default by Spain or Italy. But then they turn around and they tell us that this buffer should not be seen as a validation of the assumption that these countries will default because they will not!

In the words of the EBA (European Banking Authority):
"The objective of the capital exercise is to create an exceptional and temporary capital buffer to address current market concerns over sovereign risk. This buffer would explicitly not be designed to cover losses in sovereigns but to provide a reassurance to markets about banks’ ability to withstand a range of shocks and still maintain adequate capital."
So this buffer is not designed to cover losses in sovereigns but to provide reassurance to markets. This is a explicit statement that we are dealing with a crisis of confidence and we are trying to combine both optimism (about sovereign debt) with pessimism (when it comes to building a large enough capital buffer) in order to improve the confidence of markets. Not an easy exercise.

Antonio Fatás
on October 28, 2011 |   Edit