European Stress Tests

trading book vs banking book/European test
Ahead of the release of the European bank stress tests, the market is focusing on the headline on the tape that they will be limited to banks’ trading books rather than their banking books. This has been out for days and is not new news and I specifically talked about it yesterday. With respect to the methodology, I wrote “Another issue will be the haircut to sovereign debt. If a bank holds it in their trading book, a haircut will apply. If it’s in their banking book (held to maturity), there will be no haircut and accounting rules allow banks to shift between accounts.” Thus, while the euro reversed lower, it’s not new news.

Another key stress test assumption
Another key component of the European bank stress test is the assumption that there will be NO sovereign defaults. Thus, a sovereign bond in a trading account can be marked to market with a haircut based on its current trading level but the banking account assumes held to maturity and a repayment at par. The entire problem with this whole exercise therefore is the lack of a true worst case scenario which the bond markets have signaled is a real possibility as evidenced by the CDS level of Greece for example. The EU assumes their version of TARP and Greece’s separate package, prevents any default.

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