On October 23, ECB president Mario Draghi announced new bank stress tests. At the time, I offered a “Draghize” Translation. Here is a small snip.

Translating Draghize

For those of you who do not speak Draghize I offer these translations.

Draghize: “Banks do need to fail to prove the credibility of the exercise”.
Mish: We are carefully scrutinizing several non-critical banks, looking for a couple of scapegoats, hoping to fool the public regarding the credibility of the exercise.

Draghize: “If they do have to fail, they have to fail. There’s no question about that.”
Mish: If any big banks are in trouble. They won’t fail. There’s no question about that.

Draghize: “The test is credible because the ultimate purpose of it is to restore or strengthen private sector confidence in the soundness of the banks, in the quality of their balance sheets”
Mish: The test is credible because we say it is.

War Erupts Over How Much to Water Down Stress Tests

Via translation El Confidencial reports War between Spain and Germany Erupts Over the Hardness of Stress Tests

The new stress tests of European banks have caused the outbreak of a new confrontation between the governments of Spain and Germany. Until now, it was Spain who argued in favor of a tough exercise, similar to what Spain had to undergo when seeking bailout funds.

By contrast, Germany (supported by France and Italy) preferred more lax exercises that do not bring to light the shame of their banks balance sheets of billions in toxic assets, including Spanish mortgage securitizations.

But now the German authorities found one flank to counterattack: the huge public debt exposure of Spanish banks, which they believe should be penalized in these exercises, which can be catastrophic for our financial system when it just starts to lift head.

Sovereign Debt Not All Risk-Free

The German authorities consider that if the tests need to be hard, then they should be hard in every way, including sovereign debt. In addition, the German central bank seeks to distinguish between the sovereign debt of their country and peripherals. It is what they call “enforce the triple A”.

The penalty is a recurring request from the Bundesbank. Its president, Jens Weidmann, has warned several times about the risk posed by this link between governments and entities, and has called for a regulatory change that public debt is not considered a risk-free asset.

“It makes no sense that risk-free treatment is given to BBB Spain titles. Sovereign debt cannot all be considered as zero risk equally. Only those with the highest rating can be considered risk free” is the argument from Germany.

Germany Complains About the “Carry Trade”

Weidmann’s claim is deeper than a mere fight stress tests estate. In its latest monthly report, the Bundesbank takes offense at the stratospheric rise in the positions of the Spanish banking debt: an increase of 133 billion euros over two years, to around 300 billion euros today. This is explained by the famous carry trade with which banks borrow very cheap on the open bar ECB liquidity at 0.75%, then invest in public debt paying 4% interest.

Spanish officials claim it makes no sense to penalize these asset as if they were bad loans. But the answer to this argument is simple: a stress test is by definition a simulation of a worst case scenario that the current (or adverse stressed scenario) and that scenario should take a further fall in bond prices and an increase yields.

If the Bubdesbank imposes its criteria, the result can be disastrous for some of our institutions. Some industry sources are confident that the Spanish government reaches a deal with the German to “not to hurt each other.”

Germany Convinced of Easy Stress Tests

Via translation, also consider Merkel stands up to Guindos Regarding Stress Tests

According to a source familiar with the situation, “Germany is convinced that the test will be very light because of so much opposition to make the stress tests a serious exercise.”

In fact, postponing these tests from the last quarter of 2013 to the first quarter of 2014 is another sign of the imposition of the German thesis. Neither France nor Italy wants very rigorous stress tests so as to not aerate the shame of their own banks.

French reluctance is justified by the enormous exposure with their banks in recent years. As for the Italians, “they are in a state of denial as that Spanish banks had before the disaster,” explain the sources cited. “And the worst is that they usually get away with it, not least because Mario Draghi is Italian.”

“Deal to Not Hurt Each Other”

In return for watering down stress tests on certain toxic assets that French banks, German banks, and Italian banks do not want, industry sources think a deal will be reached to also not include skyrocketing sovereign debt of Spanish banks.

Conclusion: expect another stress-free test.

Mike “Mish” Shedlock