Stress tests failed to test banks

THE downgrade of a dozen UK banks and eight Portuguese banks on Friday morning ended another tumultuous week in the European banking sector. The Greek farce has dragged on so long that it has fallen from the headlines, despite its potential to bring Europe crashing down around our ears. Instead, focus has shifted to the banks themselves and their holdings of toxic Hellenic debt. These holdings highlighted the flawed methodology in the European bank stress tests carried out earlier in the year.

According to Moody’s, the timing of the downgrade of the UK banks was largely driven by the government removing its systemic support for the seven smaller institutions and the reduction of systemic support for the five larger, more systemically important financial institutions.

There was the usual “RBS is disappointed that Moody’s announcement did not reflect the significant progress the bank had made to restructure its finances.” But we have heard this statement with “RBS” substituted for Greece or Portugal or Dexia so many times that it has become a formality.

Two of the groups downgraded – RBS Group and Lloyds Banking Group, both part state owned banks – were the worst performing of the FTSE 100 over the course of Friday’s trading, but it was a small move by the standards of the volatile market conditions that have marked recent months. RBS fell just over 3 per cent of its opening price to recover within 0.74 of its open by the end of Friday trading.

All in all, it could have been worse. The downgrade of the dozen UK banks and building societies has come and gone and the world isn’t over – Lloyds announced that it accepted that Moody’s was simply reflecting what was already perceived by the market and that the downgrade would have little impact on their funding costs. “UK bank balance sheets are strong and the direct exposure to Greek bonds is very small so the Moody’s downgrade shouldn’t play a significant part in further selling of the sector,” says Jordan Lambert, a trader at SpreadEx. “Many UK banks – including Barclays, RBS and Lloyds – are trading at substantial discounts to their book asset values which offers great value for investors over the long term.”

For the Portuguese, the downgrades are part of a different and more serious story. Already having difficulty in accessing wholesale debt markets, this downgrade will push funding further out of their reach. This move underlines the North-South divide in the financial equities market – a divide that is unlikely to disappear soon.

What is clear from last week’s banking calamity is that the stress tests conducted in July by the European Banking Authority were wholly unfit for purpose. Dexia – for whom a priest is on hand to deliver the last rites – passed the tests with flying colours and deemed to be in “excellent” condition. “If they are going to run another round of stress tests, they need to be completely thorough,” says Michael van Dulken, head of research for Accendo Markets. “The way that they were conducted in July and the results that they produced were dangerous – giving investors a false sense of security.”

According to van Dulken, Friday’s trading teaches an important lesson. Though you might have heard news of the downgrade and expected UK banks to take a hammering – and positioned yourself accordingly – that didn’t materialise. Instead you should trade what you see. Not what you want to see.