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Europe struggles to match U.S. bank-test resolve Add to ...

Europe's struggle to thrash out a thin outline of its bank stress test and agree consistency bodes ill for hopes the exercise will provide the transparency and resolve needed to revive investor confidence.

There are clear splits in the 27-country European Union about how to model the test and how much to divulge. French Economy Minister Christine Lagarde admits discussions will go to the last minute.

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Test results are due out on July 23. It is impossible to tell from outline plans unveiled last week if the tests will be truly severe, will publish more than a simple "passed/failed" label for every bank, and, crucially, what will be done with the failed ones.

Comparing the exercise with last year's U.S. stress test, which set an industry benchmark and turned around market sentiment, shows the European version - so far at least - falls short on several counts.

"All these stress tests mean that we are peeling away layers of the onions, but chances are we are not going to get the full clarity that we as investors deserve," said Neil Dwane, chief investment officer for Europe at equities specialist firm RCM.

"The real difficulty with the quantum of the stress tests is that each set of banks inside each of the EU economies faces slightly different stresses," he said.

The U.S. stress scenario was moderate and reality turned out worse, but the test did provide real information about possible losses and was widely regarded as successfully helping to restore confidence. It underpinned a strong share price rise.

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The Committee of European Bank Supervisors (CEBS), which is co-ordinating the European tests, has heeded some lessons from the U.S. health check, but needs to take on board more of the best features, analysts and investors said.

The tests involve 91 banks, compared with 19 in the U.S. It is hoped that will make the European process broader - rather than backward. Top banks such as Santander and BNP Paribas will be tested, and smaller names such as Greece's Alpha Bank and Germany's Landesbank Berlin.

European regulators are still haggling over details and investors worry that the process will be hampered by the lack of central authority. Brussels is not Washington, and there is the threat of more political meddling in Europe's arduous process.

Most notable is the thorny political issue of how to handle holdings of sovereign debt.

CEBS will include a sovereign risk shock element, which is expected to see "haircuts" of about 40 per cent on the nominal value of Greek bonds, for example. But that is only for bonds held in banks' trading books, and not the banking book.

Other big unknowns include the scale of "haircut" on Spanish and other bonds; what the minimum solvency level will be (expected to be a Tier 1 capital ratio of 6 per cent); and how long banks will have to raise funds, or where back-up cash will come from.

The U.S. test process helped a recovery in bank stocks. The KBW bank index rose 30 per cent from February to the end of May, and was up by half through to the end of 2009. The stress tests were not the only supportive factor in a depressed sector, but they helped swing the mood, analysts said.

But anyone hoping for a similar reaction in Europe is likely to be disappointed even if the tests are transparent and tough.

Goldman Sachs analysts said that's because European banks have already raised about €300-billion ($395-billion) since the start of the crisis, the U.S. tests provided materially new information whereas European regulators and investors should already know most of the facts, and Europe's bank shares already reacted strongly to the U.S. process.

The U.S. stress tests, or Supervisory Capital Assessment Program (SCAP), used assumptions including a fall in GDP, a rise in unemployment and a drop in house prices, similar to parameters to be used in Europe.

CEBS's test assumes GDP sags 3 percentage points below current forecasts over two years. That is seen as tough enough, but there is less clarity on how severe losses will be on holdings of government debt and what's in store for banks who need capital.

Key to the U.S. process was providing transparency, a severe enough test, and a backstop to recapitalize weak banks.

In April last year, two weeks ahead of the release of the test results, U.S. officials released a white paper on the methodology and assumptions that SCAP would use, clarifying a lot of issues on the minds of investors and analysts. No such move has been forthcoming in Europe.

Ten of the U.S. banks tested were found to need a combined $185-billion (U.S.) and were told to raise capital or accept taxpayer help. After asset sales or restructuring the capital need for banks including Citigroup Inc. and Bank of America Corp. was about $75-billion.

"The U.S. had a kitty behind it and we don't have that commitment of a plan to deal with what comes out of the stress test," said Colin McLean, managing director at fund manager SVM in Edinburgh.

The European tests are not expected to force massive cash calls, partly because of the sums already raised, but should show up pockets of weakness.

About €90-billion could be needed under a severe scenario, but less than €5-billion of that would be needed by publicly listed banks, whereas regional German landesbanks could need €37-billion and Spain's cajas could need €12-billion, Credit Suisse analysts estimated.

They said the process was a symbolic test of Europe's ability to stand behind its banking system, to demonstrate that political, legal and administrative structures can provide an effective lender of last resort to the euro zone.

"If it fails to achieve this, the consequences could be severe in terms of liquidity hoarding and further breakdown of bank funding markets," Credit Suisse said.

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