Results of the 2011 EU Stress Test Released

Sources:
FT: EU Stress Test Pass Rate Under Fire
WSJ: Few Banks Fail EU Exams
Economist: Europe’s Stress Test: Disease and Cure

The European Banking Authority (EBA) recently released the results of the 2011 EU-wide stress test. While analysts expected that fifteen to twenty banks would fail the test, only eight banks out of ninety banks from twenty-one countries failed to meet a minimum standard—a core Tier-1 capital ratio (a measure of a bank's strength to absorb losses) of 5 percent—after enduring the test’s worst-case scenarios. A German bank, Helaba, also failed the test, but the bank did not allow the EBA to release its test results. ATE, a Greek bank, was the worst performing bank with a core Tier-1 capital ratio of minus 0.8 percent.

Investors and analysts claim that the test was not tough enough and failed to restore confidence in Europe’s financial markets. In particular, the test’s worst-case scenario did not include the chance of a Greek default. EBA officials also agree that the test was not rigorous enough in part due to “conflicting political pressures” from banks and governments. However, the EBA officials defend the test, saying that the test is still valuable because investors and analysts now have access to data about banks’ exposures to sovereign assets, including Greek debt. Also, Andrea Enria, chairman of the EBA, said that that the test had been “a catalyst for pressure to raise capital.” Over the four months from the end of December to the end of April, banks raised around €100 billion of additional capital.

The EBA formally recommended that national regulators should require eight banks that failed the test to raise fresh capital (€2.5 billion) by the end of this year. Also, sixteen additional banks that barely passed the test with the ratios of between 5 and 6 percent need to improve their capital position by April 2012. Spain was the worst performing nation. Among those twenty-four failing or nearly failing banks, twelve are Spanish, including Caja de Ahorros del Mediterraneo, which will be required to raise additional capital of €947 million. If these banks cannot raise the capital, their national governments may have to provide assistance to them. The EBA will publish two reports on the progress those banks make in February and July next year.

America’s Debt Crisis

Sources:
Economist: America's Debt: Shame on Them
GuardianMedia:U.S. Budget Ceiling Standoff
WSJ:Obama Backs New Senate Debt Plan ; Gridlock for Debt Talks

Earlier this month, United States President Barack Obama announced his support for a $3.7 trillion deficit-reduction plan revealed by a group of six Republic and Democratic Senators. The proposal comes as the latest effort on the part of the President to shrink the deficit and strike a deal on the government’s debt ceiling of $14.29 trillion by August 2. Raising the debt ceiling is an urgent matter, as treasury officials have warned that the government will not be able to pay all of its bills by August 2 without an increase in the debt limit by then.

Among the government’s financial obligations that will be affected are Social Security benefits, military pensions, contractor payments and interest on its debt. Similarly, the United States faces a possible down grading of its triple-A rating by all three major credit rating firms if the President and Congress do not reach an agreement to increase the debt ceiling. This possible rating downgrade is especially troublesome as a lower rating could increase borrowing costs for the government, households and businesses.

Under the United States separation of powers system, Congress is in charge of the spending power and as such it is the branch of government that must authorize any extension of the debt ceiling. Currently, there are a variety of different plans that Congress is considering. The front runner among these plans is the so-called “Gang of Six” Plan, named after the six Republican and Democratic senators who proposed it. Under this plan, the country’s deficit would be cut by $3.7 trillion over 10 years. The deficit reduction would come from spending cuts (74%) and new taxes (26%). It would impose spending cuts and caps in the cost-of-living increases for Social Security and other programs. Also, the plan would make big changes to the tax code by lowering personal and corporate tax rates, eliminating the Alternative Minimum Tax, and reducing many deductions and tax breaks.

Other proposed plans include the McConnell/Reid “Plan B” which would allow the president to raise the debt ceiling by $2.5 trillion in three steps through 2012 and the House GOP’s “Cut, Cap, Balance” plan under which spending would be cut by $2.4 trillion over ten years and a statutory spending cap with a constitutional amendment for the president to submit a balanced budget each year would be required.

CFTC Adopts New Manipulation Standard

Sources:
FT: US Derivatives Watchdog Gets More Firepower
NYT: Regulators Finalize New Derivatives Rules
WSJ: CFTC Expands Its Power to Pursue Fraud, Manipulation

Last week, the Commodity Futures Trading Commission (CFTC), the federal agency charged with regulating derivatives, finalized the first five new derivatives regulations required by the Dodd-Frank Wall Street Reform and Consumer Protection Act. One of those rules will give more power to CFTC lawyers to pursue manipulation in derivatives and commodity markets. Under the new regulation, CFTC lawyers only need to prove that traders acted “recklessly.” Previously, however, CFTC lawyers had to prove that traders had the specific intent and the ability to distort market prices and that their actions in fact distorted the prices of derivatives or commodities. Under the former standard, the CFTC prevailed only once at trial in the past thirty-five years.

Under the new regulation, the CFTC is also expected to pursue insider trading cases. Its new manipulation regulation is based on the Securities and Exchange Commission’s insider trading regulation which also makes illegal for traders to trade using “material nonpublic” information. According to Gregory Mocek, a former CFTC Director of Enforcement, the CFTC will bring enforcement actions against large commodity producers who make trades using their knowledge about supply and demand in the markets without informing counterparties of such non-public information.

Some criticize that the new manipulation standard is “too broad” and difficult to enforce. "The lack of clarity on how the broad new standards in the final rules will be applied has the potential to chill legitimate trading and reduce market liquidity," said John M. Damgard, the president of the Futures Industry Association. Scott O’Malia, a Republican Commissioner on the CFTC also expressed concerns that the new standard is vague and may add “confusion to the markets.”

In addition to the manipulation standard, the CFTC also approved another regulation that requires hedge funds and large traders to submit daily reports about their derivatives trading. The CFTC still has to finalize over 40 new derivatives regulations and will not meet the July 16 deadline. The new regulation will apply to commodity futures as well as the over-the-counter swaps markets.

Argentina’s Crisis Can Shed Light into Greece’s Future

Sources:

WSJ: Argentine Episode is Little Comfort for Greece
IMF: IMF Executive Board Completes Fourth Review Under Stand-By Arrangement for Greece
World FactBook: Argentina's Economy

Last week the International Monetary Fund (IMF) completed its fourth review under the Stand-by Arrangement for Greece. This review allows for the immediate disbursement of €3.2 billion to the country, making the IMF’s total disbursements nearly €17.4 billion. Although Greece’s economic adjustment program has continued to make some progress and a return to positive economic growth is expected by the middle of 2012, the economy is extremely fragile and fiscal adjustments are to come in the future. Over the past ten years, there has been a wave of financial crises all throughout the world. But perhaps the one that resembles the most to that of Greece is the collapse of Argentina’s economy in 2001.

There are strong parallels between Argentina and Greece. Both countries have overvalued their currencies, suffered from undisciplined fiscal policies, and taken advantage of apparent stability, in order to take on a lot of debt. For instance, in 2001, Argentina’s economy was in a very similar predicament as that of Greece. It was crushed by debt and its exports crippled due to an overvalued peso. This caused the country to default on its foreign debt and put an end to the currency’s 1-to-1 peg to the U.S. Dollar. The economy bottomed out that year, with real Gross Domestic Product (GDP) 18 percent smaller than in 1998 and almost 60 percent of Argentineans under the poverty line. Nonetheless, after the devaluation of the peso and the default on its debt, Argentina‘s economy experienced exponential growth in the years to follow.

However, Greece’s economic recovery may not come as easy as Argentina’s did. This in part because the solutions used by Argentina to combat the crisis may not work for Greece’s economic troubles. One of the main issues is Greece’s deep integration into the European Union, which makes it extremely difficult for the country to renege on its debts or devalue its currency the way Argentina did. Another factor to consider is that even if Greece’s debt payments were eliminated, the country would still have a budget deficit equal to about three times the size of Argentina’s in 2001. Lastly, one of the reasons why Argentina was able to emerge from its economic crisis so quickly is because of its strong farming sector which allowed the country to exploit the weak peso by exporting to the world. However, Greece does not count with a strong farming sector which is going to make it even more difficult for the country’s economy to recover.

Uruguay’s Economic Recovery through Innovative Policies

Sources:
World Bank - Country Partnership Strategy for the Republic of Uruguay
World Bank - Uruguay: From Crisis to Opportunity
U.S. Dept of State - Uruguay's Economy


Uruguay has come a long way since 2002, when it faced one of the steepest economic and financial crises to hit the country in a decade. The Argentine withdrawals from Uruguayan banks and the devaluation of Brazil’s currency caused Uruguayan goods to become less competitive. All these factors, along with the outbreak of foot and mouth disease, led to massive amounts of borrowing from international institutions and financial instability in the country. However, despite the severity of the crisis, Uruguay’s economy has bounced back, in large part due to the aid of the World Bank.

According to a recent World Bank report, Uruguay has proven very successful in its implementation of the Bank’s initiatives to bolster economic and social recovery. Poverty rates have decreased, the national debt reduced, and the health care system underwent significant reforms. In addition, the Bank also helped Uruguay to eliminate foot and mouth disease, boosting the country’s image as a reliable beef exporter.

The reforms proposed by the World Bank included structural changes and short-term stabilization policies as a way to shield the country from external economic shocks. These policies included strengthening the financial sector through a flexible menu of lending and non-lending services, developing local capital markets through innovation and infrastructure, and finally, cutting the external debt and reducing the role of the US dollar in the local economy. The Bank also sought to provide financial and technical support to Uruguay by providing loans in local currency and lowering the cost of financing.

Supported by the Bank’s program, Uruguay’s economy achieved a 6.6 percent growth on average from 2004 to 2008 and poverty declined by nearly 39 percent over the last 8 years. Public debt had decreased from 79.3 percent of Gross Domestic Product in 2005 to 60 percent in 2009. Also, with the aid of the Bank-financed Non-Transmittable Diseases Project, Uruguay was able to restructure its health system in order to include more accessible primary care services to the population.

Bank of Moscow to Receive the Largest Bailout in Russia

Sources:
FT: Bank of Moscow Rescued With $14bn State Bail-out
WSJ: Russia Gives Bank $14 Billion Bailout
NYT: Regulators Provide $14 Billion Bailout for Bank of Moscow

Bank of Moscow, the fifth largest bank in Russia, will receive the largest bank bailout ($14.5 billion) in Russia’s history. The bailout was necessary due to the problem loans extended to the bank's former management. VTB, another Russian bank that acquired a 46.5 percent stake in Bank of Moscow last February, recently found that the size of the problem loans amounted to 250 billion rubles ($9 billion), representing almost 30 percent of the bank’s assets. Sixty percent of the problem loans were “very bad” and were made without any collateral. According to Russia’s central bank, Bank of Moscow will receive 295 billion rubles from the Deposit Insurance Agency at 0.5 percent. Additionally, VTB will provide 100 billion rubles as well.

This bailout raises questions about the quality of regulation and supervision in Russian banking. Indeed, banks in Russia have not been considered transparent, and problem loans have been rising after the recent financial crisis as regulators have not actively responded to regulate such problems. Still, the huge size of bailout (almost 50 percent of the bank’s total assets) for a quasi-sovereign bank surprised investors. “If this kind of thing happens at such an important institution, it’s an amber light that the entire Russian banking system has to be finally cleaned up,” said Tim Ash, emerging markets economist at Royal Bank of Scotland.

Finance Minister Alexei Kudrin asked for criminal investigations, accusing the bank’s former chief executive Andrei Borodin, closely connected to an ousted mayor Yury Luzhkov, of practicing “fraudulent lending.” Investors question why VTB was not able to find the bank’s problem loans prior to its purchase of such a large share of the bank. VTB’s chief executive Andrei Kostin said that the bank’s management had not provided the bank’s actual loan book and former mayor Luzhkov “prevented anyone from asking unwelcome questions.”