Grade Inflation and the Implications for Europe


By Dr. Lynn Reaser

If only 8% of a class does not pass the exam, does it mean that the students are exceptional, have done their homework, or that the test was too easy?  It is hard to tell before probing more deeply.

Only seven out of the 91 banks failed under Europe’s recently conducted “stress test.”  These included a Greek and German bank that have already been nationalized and five Spanish banks that have been severely impacted by the country’s real estate decline.  All seven of these banks will have ready access to government funds either through their government ownership, or in the case of Spain, a promised access to a bailout fund if private sources prove inadequate.

The European test was designed to measure the capital shortfall in an economic scenario worse than generally anticipated but still plausible.  Versus a base case calling for modest real GDP growth both this year and next, the test assumed a 0.2% decline in 2010 followed by a 0.6% drop in 2011 in the Eurozone.  The major shortfall of the test was that it did not cover the implications for banks of a restructuring or default on the bonds issued by Greece or another country.  Banks were also only asked to assess the impact of a reduction in the value of bond holdings in their trading accounts instead of on their balance sheet where bonds are held until maturity or until sold. 

As a result, the capital shortfall was assessed at $4.5 billion versus much larger amounts that had been forecast.  Financial markets expressed some relief, but most observers know that the story is far from over.

European banks will still need to raise sizable amounts of funds to strengthen their capital positions regardless of the test results.  If they fail to raise the necessary funds, they might be forced to shrink their loan holdings, which could severely crimp the ability of Europe to grow its economy.  Governments could provide a backstop, but let’s hope that private investors will be less stressed.

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