German banks cheated on European Central Bank's stress tests

A group of financial experts from Deutsche Bundesbank, Imperial College London and the US Federal Deposit Insurance Corporation has recently reviewed the European Central Bank’s (ECB) 2014 asset quality review (AQR) data and analyzed whether banks “dress up” for the regulator by changing their assets’ risk composition.

As it turned out—yes, they totally do.

The researchers reviewed various statistics of 130 banks in the eurozone that have €22 trillion ($24 trillion) in assets before and after the review was conducted in 2014, including 25 German banks.

They concluded that soon after the test was announced in October 2013, reviewed banks invested in low-risk assets. But that, after the test was done, the banks swapped back to high-risk assets.

“We find that, after the ECB’s announcement of the AQR, reviewed banks increase their share of securities that have top-tier rating and reduce their share of supply of credit to riskier firms,” the report stated.

“In the period after the AQR compliance though, we find that reviewed banks fully reload back on riskier securities (similar to the pre-ECB announcement level); however, this is not the case for riskier credit,” it added.

Such results suggest that banks intentionally changed the composition of their assets before the test in favor of safer assets—and undid this almost immediately after the exercise. As a result, the study put the banking industry in a favorable light.

Worse, it’s not even a secret.

The report said, “There have been several instances of banks that have passed the stress tests and then failed within a short period [of] time thereafter,” adding that, “supervisors are aware of the risk-masking incentives by banks.”

Notably, a very similar strategy—called “window dressing”—is a common practice among mutual fund and other portfolio managers, who use it to inflate a fund’s performance before presenting it to clients or shareholders near the end of a reporting period.

As the report indicates, major EU banks also don't shy away from such “high risk—high reward” strategies, effectively cheating the regulator.