That the long awaited results from the EU bank stress tests (released late on July 23) failed to move the markets substantially should come as little surprise. For the stress test results to cause a major re-pricing of assets in the short run, one of two scenarios would have had to take place. On the downside, a large multi-national bank, which was perceived of as secure, would have had to fail or at least been revealed to have major risks that were previously not priced in (the seven failed banks were: Hypo Real Estate, ATEbank, Banca Civica, Unnim, Cajasur, Espica and Diada). As it was, almost all of the banks that managed to fail the test were already under severe pressures if not undergoing government led restructuring plans. At the same time, all of the biggest banks from France, Germany, UK, Spain, Austria and others passed the tests with flying colours.

For the markets to have reacted to the upside, the methodology and threshold for passing would have had to come out much more strict than anticipated. What actually happened was that the methodology was revealed to omit major exposures to risk, which clearly suggests that the uncertainty risks priced into equities are likely to linger. Three key omissions:

First, the CEBS made it explicitly clear in its summary report that liquidity risks were not measured. Considering that it was a liquidity crisis above all else which caused the panic in the global banking system after the fall of Lehman Brothers in September 2008, I feel this is a major omission worth noting. As a result, uncertainty over exposures to short-term refinancing across the banking sector and the risks posed by a sudden spike in investor risk aversion will continue to be priced into the market.

Second, the sovereign debt exposures of the banks were only measured against trading portfolios. This means that exposure to the much more substantial amount of treasuries held until maturity in banks’ securities portfolios was not taken into account in the banks’ risk profiles. To be sure, the CEBS made it clear that a sovereign default scenario was not taken into account under this stress test, which would explain why only the trading portfolios were measured. That said, with a restructuring of Greek debt within our core scenario by 2013, I believe that the uncertainty surrounding bank treasury holdings will remain a firm risk.

Third, I note the underlying problem of any stress test, which is the inability to measure unknown risks, liabilities and exposures. By definition, stress tests can only measure known exposures and risks and reveal only that which is already discernible on publicly available balance sheets. As was made evident by the collapse of Lehman Brothers, the biggest risk that can undermine market confidence are unknown liabilities which have previously not been priced in. In the aforementioned case, the uncertainty over credit default swap (CDS) exposures resulting from the collapse of Lehman, which was the counterparty for billions of dollars worth of CDS, resulted in a massive exodus in capital from risky assets.