Tuesday, July 27, 2010

EU Stress Test

The big news at the end of last week was the release of the results of the European Union’s “stress test” of its banking system. As it turned out, only 7 of the 91 financial institutions that were examined would “fail” under the adverse scenario used in the test, with an estimated capital shortfall of only about $4.5 billion. Overall, the results were much better than the market was expecting, although there was plenty of debate about the particulars of the test and whether it was “stressful” enough. Equity investors seemed pleased, with stocks rallying on the news and extending the bounce that began earlier this month.

While the stock market reaction was encouraging, we were more interested in the reaction in the interbank lending markets. 3-month EURIBOR (Euro Interbank Offered Rate) has continued to climb following the results of the test, signaling that banks are still distrustful of one another and so are increasing the rate they charge each other for short-term loans. If the banks themselves aren’t sold on the results of the test, that is very telling. So while we’d love to believe that the system risk fears in Europe are safely behind us, the behavior of the short-term funding markets warns that it would be premature to do so.

Chart: 3-month EURIBOR