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Stress Testing the European Banking System

Viral Acharya on flight from US treasuries

Objective capital shortfall estimates such as ours can provide a valuable defense mechanism against any political efforts...

With the financial world now reviewing the European Central Bank’s assessment of the riskiness of banks across the eurozone, an analysis prepared in anticipation of that assessment by NYU Stern Professor Viral V. Acharya and a colleague could serve as a benchmark for the ECB’s accuracy, thoroughness, and independence.

In “Falling Short of Expectations? Stress-testing the European Banking System,” Professor Acharya, the C.V. Starr Professor of Economics in Stern’s finance department, and co-author Sascha Steffen, of the European School of Management and Technology, calculated the capital shortfalls of banks using publicly available data and a series of shortfall measures. “We documented which banks will most likely need capital, where a public backstop is likely needed, and, as many countries are already highly leveraged, where an EU-wide backstop might be necessary,” says Professor Acharya.

Among the results, the authors’ analysis showed that the banking sectors in Belgium, Cyprus, and Greece were likely to require public backstops, while also suggesting large shortfalls in core European countries such as France and Germany.

The authors strove to produce a meticulously documented study that would encourage transparency in the Asset Quality Review (AQR) process. “National governments might be inclined to influence the design of the AQR to prevent their banks from being singled out in the stress tests,” Professor Acharya explains. “This raises the difficult question as to whether the AQR will eventually live up to expectations and restore confidence and creditability in the ECB as a single supervisor. Objective capital shortfall estimates such as ours can provide a valuable defense mechanism against any such political efforts to blunt the effectiveness of the proposed AQR and the intended recapitalization of the euro area banking system.”