EU stress tests: Europe has answered some questions about its bank stress tests. Regulators have made the examination more credible by expanding it to 91 lenders and including a sovereign debt sell-off. But it's still not certain how much detail banks will have to disclose, or even what the pass mark is. The exercise could still prove a flop.
The list of 91 lenders included in the test represents 65 per cent of Europe’s bank assets and at least half the bank assets in each country. This means Germany’s Landesbanken and Spain's Cajas – the institutions probably most in need of extra capital – are caught in the net.
Individual banks will also have to disclose how they performed. Policy makers have also bowed to market pressure and included a sovereign debt shock among the scenarios that banks must consider. That’s not as good as explicitly testing for a sovereign default, but it’s the next best thing. Banks will have to assume that Greek government debt falls by a further 16-17 per cent from already-depressed levels. For 10-year Greek bonds, that implies a price of less than 60 percent of their face value - roughly what investors think they would fetch following a default. Yet the stress tests are still far from transparent. For example, it’s not clear how they will deal with banks government bond holdings that are not currently marked to market. These would be unaffected by even a severe market sell-off, but would suffer large losses if an EU government actually defaulted.
Second, regulators have not spelled out how much detail banks will have to disclose. The U.S. stress test last year forced banks to produce summary balance sheets, allowing investors to make up their own mind about whether the tests had been sufficiently severe. With a little more than two weeks to go until the results of the tests are made public, investors are also still in the dark about what regulators consider to be a pass mark. The worry is that they won’t set the bar until they have seen the results. But if any banks were waved through with less than 6 percent Tier 1 capital ratio under stress, the market would probably take a dim view.
EU regulators have belatedly realised that the stress test will be useless unless it is viewed as credible. The recent improvements are an important step forward. However, regulators will still have to answer a few more important questions before the exercise can be deemed a success.
