European regulators say they will publish stress-test results of 91 banks - almost four times as many as last year's tally - but did not reveal the nature of the tests for the lenders' potentially explosive sovereign debt holdings.
The stress tests announcement by the European Union's Committee of European Banking Supervisors (CEBS) came as the European Central Bank left the benchmark interest rate at a record low of 1 per cent in apparent recognition that improving growth rates are being offset by fears about a second banking crisis.
ECB president Jean-Claude Trichet said he welcomes the stress tests, results of which are to be published July 23. "Appropriate action will have to be taken where needed," he said, referring to any effort by governments to recapitalize banks that fail the tests.
The tests will be done by the EU's national banking regulator in co-ordination with the CEBS. The banks to be tested represent two-thirds of the EU banking industry, including 27 Spanish banks, 14 German banks, six Greek banks and four British banks. The smaller Spanish and German banks, laden with dud real estate loans, are considered the most vulnerable.
Key to the test is the measure of the banks' so-called Tier 1 capital - a ratio of capital to assets that is an important measure of financial strength and ability to withstand economic, financial and investment-portfolio shocks. The EU - which wants to see that ratio at 6 per cent - hopes the tests, and the transparency that will come with them, will restore confidence in the European banking system in the same way that last year's U.S. tests marked a turning point among American banks.
In London, UniCredit chief economist Marco Annunziata said, "The publication of the banks stress tests is now the make-or-break challenge for the euro zone, a one-shot opportunity to clean up the banking system, bolstering balance sheets and investor confidence. If it is done right, Europe should be able to dispel once and for all fears that a Japanese-style lost decade might lie ahead."
The question about the stress tests is whether they will be stressful enough, especially on the banks' bulging portfolios of sovereign debt. Daniel Gros, director of the Centre for European Policy Studies in Brussels, said on BBC Thursday that it wasn't clear whether the tests could determine whether "any banks could survive a restructuring of Greek debt" or another sharp downturn in the already gutted Spanish real estate market.
Regulators have told the banks that the tests may assume a loss of about 17 per cent on Greek government debt; 3 to 5 per cent on Spanish debt; 8 per cent for Portuguese debt and none of German debt.
The credit markets, however, suggest that Greek bonds would lose much more than 17 per cent should the Greek government default, a scenario some analysts predict. Derivatives known as recovery swaps are trading at rates that imply investors would get a mere 40 per cent back on the face value of their Greek bonds - a loss of 60 per cent.
Various reports said that as many as 20 of the 91 tested banks could fail to pass the Tier 1 capital ratio. In a comment piece, Mr. Gros said, "The real problem is that the EU's banking system is so weakly capitalized, it cannot take any losses, while also being so interconnected that problems in one country quickly put the entire system at risk. Until the banks' balance-sheet problems are dealt with decisively, financial markets will be on edge."
Testing for stress
To assess resilience of the EU banking sector and banks' ability to absorb further possible shocks on credit and market risks, including sovereign risks. To assess current dependence on public support measures.
The stress-test exercise will include the major EU cross-border banking groups and key domestic credit institutions in Europe.
Results of the stress test will be disclosed, on an aggregated and a bank-by-bank basis, on July 23.
A stress-testing exercise does not provide forecasts of expected outcomes, but rather a what-if analysis aimed at supporting the supervisory assessment of the adequacy of capital of European banks.