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European stress tests: Send in the clowns

July 6, 2010: 11:16 AM ET

If the ECB wants to boost confidence, it would be wise to take a page from the Federal Reserve's playbook and not look too closely at its banks' books.

by Heidi N. Moore, contributor

Political theater is so embedded in the financial crisis now that it would be unsporting to complain about it. It is still worth asking, however whether the elaborate staging will have its intended effect. The way that the European Central Bank is approaching upcoming bank stress tests right now, there's no way for investors to win.

So it is worth asking if the European Central Bank's upcoming "stress tests" of European banks will accomplish their intention of putting the markets at ease about Europe's prospects. The ECB might want to take more pages from America's playbook on this.

In 2009, shareholders and counterparties were terrified that the biggest U.S. banks, including Citigroup (C) and Bank of America (BAC), were so weak that they might be nationalized. The Federal Reserve stepped in, conducted "stress tests" and declared the banks relatively healthy; in some cases, the Fed merely required the banks to raise additional money. Many complained that the stress test results had been massaged by the Fed under pressure from the banks, to make the firms look healthier than they really were. Saturday Night Live correctly parodied the U.S. stress tests as a series of convenient accommodations moving from a graded system to a pass/fail system to "a pass-pass system." Each of the 19 major banks, then, miraculously passed; there was no other option.

In praise of the blind eye

It was a valid complaint, but beside the point. The Fed made the calculation that the markets at the time needed confidence, not math. Similarly, if the ECB's goal is to increase confidence in European banks, it might be better off not looking too closely.

It doesn't help European banks, for instance, that the ECB itself declared them in trouble just last month. The ECB's most recent financial stability report in June suggested that European banks might chalk up writedowns to the tune of $239.26 billion through 2012. Similarly, the International Monetary Fund, which worked with the ECB to structure a bailout for sovereign governments this year, predicted that German banks alone would have to write down $314 billion this year. If the ECB decides later that the banks are healthy, or that they only need a little more capital, it would look like a sharply suspicious and convenient reversal.

These critical estimations of losses are altogether too much frankness for what the ECB wants to accomplish, unless it wants to kick its struggling banks while they're down. The ECB needs to stage a light comedy, not a morality play. The ECB would need to either provide money to the struggling banks or otherwise help them get on their feet, as the U.S. government did (at enormous expense). More importantly, the ECB will have to recognize that European banks aren't the problem; European government debt is. If the ECB stress tests declare European banks weak, those banks certainly can't turn to their governments for help.

In some cases, the stress-test technique may be all too easy, however. The Daily Telegraph in London pointed out that some banks will actually be allowed to stress-test themselves. That takes it from light comedy to farce.

The ECB may be putting too much thought into the stress tests as a measure of bank health. In the end, the biggest thing the U.S. did to help its banks was not the stress tests - though they were helpful - but a quiet change to accounting rules. Regulators allowed banks to decide on their own how they accounted for their more complicated, toxic assets instead of marking them directly to the market price. Banks wanted that because many of those complicated assets were simply not selling, so there were very few market prices to judge their value. The new mark-to-market rules put an end to massive bank writedowns that were making investors nervous.

In short, stress tests are only one step to convincing the market of the stability of the banking system. The ECB will have to work more closely with the banks, as the Fed did, to strike the perfect note with its audience.

--Heidi Moore is Sweeping the Street for the two weeks that Colin Barr is on vacation.

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