Fed gold stars versus a Cypriot shambles

There is a neat irony in the Federal Reserve Board issuing the results of its latest stress-testing of its largest banks even as Europe is grappling with the prospect of another banking-inspired financial crisis.

The Fed issued the results late last week, just before the European Central Bank’s bailout plan for Cyprus’ banking system, involving a levy on depositors, including those carrying a government guarantee, was unveiled.

The proposed $7.25 billion levy and the $US12.5 billion ECB bailout is designed to recapitalise the Cypriot banking system, which is about eight times the size of the Cypriot economy, and prevent it from collapsing. The levy of deposits is apparently the result of concern within the eurozone that the bulk of the deposits within the Cypriot banking system are Russian and of suspect origin.

Not surprisingly, the plan has created panic among Cypriot depositors, raised concern about the contagion effects on depositors in other troubled economies like Greece, Italy and Spain and the potential for it to trigger runs on banks across Europe and caused the government in Cyprus to scramble to renegotiate the terms of the bailout.

While Cyprus is inconsequential in the European scheme of things it does illustrate the wider problem within the eurozone – the interconnectedness of sovereign finances and eurozone banks.

European stress-testing of its banks, while not adopting as conservative approach as the US, has found many of them short of sufficient capital but because the region has been teetering of the edge of a fiscal abyss and in effective recession ever since the global financial crisis erupted the authorities have been reluctant to push the banks to recapitalise at a faster pace.

That has, of course, left them vulnerable and exacerbated the financial fragility of the weaker members of the eurozone. Spain, for instance, set up a ‘’bad’’ bank to hold and manage the worst assets within its system after it was forced to nationalise Bankia last year. The bad bank, known as Sareb, has more than $60 billion of dud assets in it.

The US is now into its third round of annual stress testing. Its test are based on worst-case scenarios, against the backdrop of a deep recession in the US, Europe and Japan. In the test unemployment is set at about twice current levels, the share market at about half current levels, house prices are assumed to decline significantly and financial markets generally to be severely disrupted.

As a result of the latest tests of 18 institutions, the Fed objected to the capital plans of only two institutions, Ally Financial and BB&T Corp.

From the first tests that were undertaken in 2009 the amount of tier one common equity held by the 18 bank holding companies – which hold about 70 per cent of the US banking system’s assets – has risen from $US393 billion to $US792 billion and the weighted tier one common equity ratio has more than doubled, from 5.6 per cent to 11.3 per cent, partly because the banks have held onto (or been forced by the Fed to hold onto) more of their internally generated capital.

The continually strengthening condition of the US banks is occurring against the backdrop of a US economy that is showing increasing signs of life. The eurozone has weak banks in the weakest economies – the European authorities should have made a more determined effort to recapitalise the banks in the immediate aftermath of the crisis to truncate what otherwise becomes a potentially destructive relationship between the sovereigns and their banking systems. Instead they have hoped that time and economic growth (growth that has yet to develop) and ECB promises to do ‘’whatever it takes’’ would reduce the vulnerability of both.

The US bank bailouts and regulatory response were crude, costly and intrusive but may ultimately be seen to be a lot more effective, and far cheaper (the US government has made big profits on the bailout funds) than the more subtle and so far yet-to-be-successful European strategy of hoping that time and growth would repair the wounds.

In the larger scheme of things Cyprus and the fate of its depositors is of little consequence (except to them) but it does provide a preview of what could confront the eurozone if it is forced to come to the rescue of one of the larger economies and banking systems.

Given the demonstration effect provided by the precedent-setting Cypriot ‘’solution’’, let’s hope, for the sake of global financial stability, that doesn’t happen.