By Simone Meier and Louisa Fahy
October 7, 2009 | Bloomberg
Nobel Prize-winning economist Joseph Stiglitz said stress tests carried out across the financial system may not reflect the health of the banking industry.
"There's a question of whether you can trust stress tests," Stiglitz told Bloomberg News today at an event in Dublin. "If you had announced at the end of stress tests" that the banks "would not pass, it would have caused panic."
A stress test of the European Union's biggest banks published last week showed financial institutions are able to withstand an even deeper recession. Under current EU economic forecasts for 2009 and 2010, the 22 largest banks in the region would maintain an average Tier 1 capital ratio "well above" 9 percent, with none of the surveyed companies expected to see its ratio fall below 6 percent. The EU didn't publish the names of the banks it studied.
"You worry that the stress test was designed to make sure that they passed," Stiglitz, a professor at Columbia University in New York, said in the interview. "Given the high level of leverage and the high levels of default, it provided a little bit more comfort than I would have taken."
The five-month stress test was ordered by European officials after the global credit crisis prompted the U.S. to conduct stress tests on its banking system. The minimum Tier 1 capital requirement under the Basel accords is 4 percent.
Stress tests "seem to provide some assurance to the markets," said Stiglitz, a former chief economist at the World Bank. "It was remarkably reassuring to know they would at least survive the normal case if not the stress case," he said.
'Highly Leveraged'
European financial institutions have posted $498 billion in losses since the onset of the credit crunch in mid-2007, less than half the $1.08 trillion in losses reported in the U.S., according to Bloomberg data.
"The banking sector's problem, in Europe perhaps more than in the U.S., is that banks are highly leveraged," Stiglitz said. "There is a risk of a fall in the value of the assets by the amount that would wipe them out, wipe out the net worth."
U.S. stress tests found that 10 financial companies led by Bank of America Corp. needed to raise a total of $74.6 billion of capital, in results made public on May 8. Releasing the findings helped calm investors, U.S. Comptroller of the Currency John Dugan, who oversees national banks, said at the time.
European Central Bank President Jean-Claude Trichet and other officials have said the methodology used in the report, prepared by the Committee of European Banking Supervisors, differed from that used by U.S. authorities and the International Monetary Fund. The divergence in part reflects different accounting standards, they said.
'Probably All'
"We probably should have let most, probably all, of the banks fail," Stiglitz said. "I find it very ironic that people who have always been in favor of market economics all of a sudden suspended the rules of capitalism. It really undermines the functioning of the economy. It's a distortion to the economy."
The Washington-based IMF last week cut its projection for global writedowns on loans and investments by 15 percent to $3.4 trillion, citing improvements in credit markets and initial signs of economic growth. The tally was based on a new methodology after criticism of an April estimate of about $4 trillion. Losses on bad assets are projected to increase from July 2009 through next year by $470 billion in the euro area, according to the report.
Stimulus Measures
With companies still cutting jobs and the economy struggling to emerge from its worst recession since World War II, governments and central banks across Europe have indicated they are in no rush to end their special measures to revive growth. ECB council member George Provopoulos said on Oct. 6 that it is "too soon to begin withdrawing the stimulus measures" and U.K. Chancellor of the Exchequer Alistair Darling said earlier this month it was "absolutely vital" to continue supporting the economy.
"This is a situation where monetary policy has pretty much reached the limit of what it can do," Stiglitz said. "We need fiscal policies as the major lever" to fight the crisis.
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