European banking regulators have been looking to two initiatives to further calm the markets following the sovereign debt crisis that shook the continent, and the world, earlier this year. One initiative, to impose a global levy on banks, did not win wide support at last month’s summit of the G-20. The other, a stress test of many European Union (EU) banks, will produce results later this month – and some observers are worried about what might be revealed. Both efforts were designed to bring new transparency to the international banking system. But the wounds they were meant to close may remain open for some time to come.  

The G-20 summit, held in Toronto, did not dispel doubts about when, how and where to apply the controversial levy on financial institutions. The final declaration of the summit was limited to reiterating that banks must pay back to governments the many billions of dollars that were needed to save the financial system from collapse not only this year but also in 2008, when the mortgage debt crisis took hold in the United States and then spread abroad. However, the declaration gave total freedom to each country to decide how to tax its own institutions to create a fund to pay for future bank bailouts.

Although plans remain quite vague, there are various scenarios that would enable banks to “contribute in a fair and substantial” way to their own rescue efforts. Conditions for doing so have been poorly spelled out. The G-20 nations haven’t even reaffirmed the payment periods that they set before the summit, when they agreed that the global levy would begin to be applied in 2011.

This lack of precision is a big disappointment to the European Union, which has been pushing for a global agreement. The question now is whether the levy should be applied under one standard for everyone or rather should be implemented in a selective way, depending on the state of the economy and banking system in each country.

“The levy seems logical and useful to me, since the banking sector produced the bubble that was the source of the crisis we are suffering,” says Manuel Romera, director of the financial department of the IE Business School in Spain. “The reasonable thing to do is for financial institutions to pay for their mistakes. But the levy has to be designed to avoid systemic risk.” In particular, Romera fears excessive intervention by the public sector. “This market needs to be regulated, and there have to be clear rules of the game, but it must be the private sector that manages things.”

Lack of Consensus

One of the greatest challenges is the lack of consensus. Many emerging nations are opposed to a levy, as are a number of developed countries whose banks did not need any public bailout money. A major risk facing those countries that decide to move forward with the levy is whether their financial systems will wind up at a disadvantage compared with countries that don’t apply it.

But the fundamental question, some experts say, is whether it is fair to apply the levy to every financial system, without distinguishing between those countries that are healthy and those that are in need of repair.

“If this were about the sort of levy designed to repay governments for advance payments, credits and subsidies that were lost – and which the governments and banks had authorized – then it would seem correct to me,” said José Vicente Santamaría, professor of economics at Carlos III University of Madrid, adding, “There could be a corrective factor aimed at not damaging those banks that were more efficient and were less burdensome for the public treasury.” In that way, he said, the levy would reflect the principle that those who pay more in the future are those who have received more from the government in the past.

In the United States, Congress is being quite unresponsive to President Obama’s efforts to push forward with this tax. In reality, almost all of the U.S. institutions that received rescue funding have already returned the money, with the major exceptions of Citigroup and AIG.

The concept of a bank levy makes sense from a political point of view, says Mauro Guillén, a Wharton management professor and director of the Lauder Institute, since “everyone wants the banking sector to pay for its responsibility for the economic crisis.” Nevertheless, he notes two risks if the tax moves forward. The first risk is purely economic: “It would increase both the financial cost for companies as well as for ordinary citizens.” The second risk is moral, Guillén says: “If bankers put part of their money into a fund, it could lead people to believe that it is legitimate to risk more.”

Spain is one of the countries that support the idea that the financial sector should pay for future crises. In a scenario in which the greatest risk is that each European government fights a war on its own account, the Spanish government has been the first to indicate how it would channel the money collected from this levy. While there still isn’t even a defined model, the government is considering the possibility that banks would increase their contributions to the government’s Deposit Guarantee Fund, or Fondo de Garantías de Depósitos (FGD), by an amount that would vary from bank to bank according to the risks that these institutions assume. The government is proposing to raise the contribution that banks make to the FGD from the current rate of 0.01% of deposits. Those banks that take on more risks would pay more. Other liabilities such as bonds and interbank products could also be affected by the new levy.

The government has let it be known that it believes the FGD system needs to be revised because it does not meet the needs of today’s highly complicated financial sector, in which products are increasingly sophisticated. Underlying that idea is a philosophy generally defended by countries like the United Kingdom and France. They argue that the financial sector must make the economic effort to guarantee that it will underwrite the cost of any future crisis.

But financial institutions fear that if an agreement is reached to apply a levy, each country will apply it according to its own interpretation. In that regard, IESE’s Romera believes that the role of regulators must be debated in public. “We have forgotten the role of the regulator,” he says. “He has been too quiet, and he needs to have a much stronger presence when it is time to set the rules of the game. Until now, too many dirty tricks have been permitted, and there have been too many scapegoats.” He adds, “Regulators have to be supranational because each country establishes its own policies for control and supervision through its own central banks. Nowadays, we haven’t achieved any real coordination because we haven’t worked hard toward that goal.”

Meanwhile, the general feeling is that participants at the Toronto summit concentrated above all on making adjustments in public spending. A reduction in the public-sector deficit of the 20 richest countries is already a shared commitment that has a date on the 2013 calendar.

The Impact of the Stress Tests

While the debate over the levy continues, stress tests aimed at evaluating the quality of balance sheets and the solvency of banking institutions have become the major weapon that the EU wants to present to the financial markets in order to calm jittery investors. On July 23, the results of those tests – which were imposed on more institutions than had initially been forecast — will be made known.

The tests given to the 25 largest banks should not produce any great surprises. Some results, for the Spanish and German banks, for example, have already been leaked to the press. Banco Santander and BBVA are, in that order, the banks that came out best, while German banks Deutsche Bank, Commerzbank and BayernLB also received high grades.

A very different issue is the state of health of the collection of 91 institutions that have been tested as a result of pressure from the European Central Bank and the European Commission. Included in this group are a large number of midsize banks. Spanish savings banks, known as “cajas,” are also part of this group. These banks devote a portion of their dividends to social goals and have political representatives at their core. The 91 institutions are from 20 countries and represent 65% of the banking sector of the EU. Spain is submitting the most institutions to these tests – 27, of which 18 are cajas.

Some observers fear that this initiative could turn into something that has dark consequences. Markets could suffer if the tests reveal that the balance sheets and income statements in a large part of the sector are weaker than anticipated. There is no debate about whether this extra dose of transparency is needed; only about the conditions under which it should take place and how far it should go. “The stress tests totally make sense; they have always done so, and the more publicly they take place, the better,” says Romera. “For me, this is called ‘competition.’ ” Nevertheless, Romera warns of the “systemic risk that could result when this information is publicized.”

Previous experience indicates that the overall impact could be positive. At the moment, the only valid case study is the tests that the U.S. Treasury Department applied to financial institutions in the wake of the bankruptcy of Lehman Brothers in 2008. The results were excellent. That test helped U.S. markets recover a portion of the stability that had been lost.

What does Spain face? Any tensions concerning the big banks have already been set aside, so if there are any doubts, they concern the results of some institutions that are suspected of having taken a severe blow during the crisis.

Santamaría of Carlos III University is worried about the mix of big, midsize and small banks in the test and offered a soccer analogy to explain the problem. Among the Spanish institutions taking the stress test, he said, “some play in the Champions league (which competes against the best European teams) and others are in the Segunda B (the third level of the Spanish national championships). The big Spanish banks will have to be separated from the rest, and the good cajas will have to be separated from the contaminated ones. If we don’t make such distinctions, it will be bad for Spain.”

With respect to what might happen if there are negative surprises, Santamaría distinguishes between the situations facing midsize Spanish banks and the savings banks. “They are two different worlds,” he says. “The banks can merge in a matter of days if it is necessary because they are not subject to political conditions. In any case, these are two sectors that are in full restructuring mode.”

In Spain, adds Santamaría, “what’s different from other countries is that risk controls are very sophisticated. In the big banks, they have not detected any holes, and institutions have been very transparent when it comes to communicating and making bad-debt provisions for real estate assets that have been adjudicated [awarded to the banks by the courts] since the crisis began. There have been moments when things were difficult for awhile, such as the way the Madoff case affected Banco Santander, but those situations have been resolved very quickly.”

Nevertheless, there is a growing debate about what level of scrutiny and how much transparency is involved in the tests. There are doubts about what type of scenarios the supervisors will choose when they evaluate the sector’s state of health. Above all, there are concerns that some key elements of the results won’t be divulged to the public. What is known so far is that the data about each bank will be released on July 23. What isn’t known is the level of detail that will be provided to the markets. Santamaría favors the idea that “each regulator should apply the [same] criteria of transparency used in the financial system of the EU, but those criteria should be made known; their methodology should be endorsed by recognized experts, and they should not conflict with the criteria used by ratings agencies and supervisors of [individual national] governments.”

It makes sense to be careful, says Santamaría, since the key to success is “whether most people are going to trust the results of the tests of the 91 institutions. That is to say, if the big investors, politicians and opinion leaders agree that the diagnosis is valid. To do that, the policies of the supervisors must be harmonized. The simple fact that these tests get done is not enough.”

The skeptics still have their doubts about the transparency and the effectiveness of this process. In recent weeks, The Wall Street Journal and Financial Times have taken issue with the EU because it won’t say what measures it will impose against banks that fail the tests. The skeptics also wonder why the authorities have not publicized the methodology of the tests and the requirements that will have to be fulfilled, the way the United States did for its tests. Another big criticism is that people don’t know how the tests are going to measure the exposure of these institutions to sovereign debt. In other words, they believe that investors are being asked to make a leap of faith even as suspicion grows that the tests are not going to be as demanding as they should be. Many people wonder whether this disconnect could even force the markets to close for a time when the test results are revealed.

Winners and Losers

“Transparency is what provides tranquility, because markets are worried and they want to know which banks are better and which are worse,” says Romera. “So far, the banks have not made public this data because, fundamentally, they are an oligarchy that operates undercover. Beyond that, the regulators are not all on the same page, and each European central bank has its own peculiarities.”

It is useful to remember that this is not the first time European banks have subjected themselves to stress tests. That happened in 2009, at the height of the international crisis. But on that occasion, the results were presented to the public for the sector as a whole and not bank by bank, as they will be presented now.

Clearly, the markets are going to measure the banks with a different yardstick after the tests become public. In that regard, the two big Spanish banks have a lot to gain.

“They are measuring the solvency level that the banks have, not their liquidity, the quality of their assets or the health of their loans per se,” Romera explains. “In this situation, Santander and BBVA have a great capacity to make profits, and, in the case of Santander, they have been able to finance themselves during the crisis by expanding their capital. But it is useful to remember that although they have a lot of resources, the quality of their loans is no better than that of their competition. The real guarantees of those loans are not so good.” In effect, Spanish banks are weighed down by almost 100 billion euros in doubtful loans and their rate of arrears is higher than at any point in the last 14 years. The exposure of the financial sector to the construction business is quite significant. And Santander, the largest Spanish bank, is also the institution that has been awarded the most real estate assets by the courts since the crisis began, because the owners of those properties could not continue to make their mortgage payments to Santander.

The positive impact generated by news that these two banks got the highest grades in the stress tests may be undermined in part by the fact that they are Spanish institutions, at a time when the international perception of Spain is not at its best. But Romera contends that “The big Spanish banks are quite diversified, since 40% of their business is outside of Spain. So the negative foreign image of Spain has only a relative impact.”

For his part, Wharton’s Guillén believes that “the big Spanish companies are increasingly disconnected from the economy of the country. They derive more and more of their profits from outside the country, and in terms of stock ownership they also depend less and less on Spain. So, their interests are not aligned with the Spanish economy. If this initiative doesn’t solve their problems, perhaps they don’t want to be related with Spain.”

Stock markets have made solid gains as a result of positive expectations about the tests. The share prices of Spanish banks whose test results were leaked have risen, despite the absence of details. The leaks, made during the latest meeting of the European Council, ranked Santander and BBVA as the two most solvent banks. Share prices of both institutions rose — by more than 5% in the case of Santander and by almost 7% for BBVA, and in barely two trading sessions. The markets celebrated the leadership position of the two most important banks in the Spanish financial sector, whose coefficient of solvency ratio of 13.6% is better than the European average of 11.9%.

After the results became known, José Manuel González Páramo, a member of the executive committee of the European Central Bank, told the media that the tests are necessary because “this is going to add information where until now there was nothing but rumors and, as a result, infection.” He recalled that some very solvent institutions have been forced to pay “enormous premiums for financing because they carry the name of a country in the south of Europe.” This was a clear reference to Spain, which has been very affected by the impact of the crisis on Greece and Portugal and, to a lesser extent, on Italy.