European banks may face harsher tests from market

July 23, 2010

Europe’s bank tests were not stressful enough. Only seven of the 91 lenders participating in the exercise administered by the continent’s regulators will need extra capital to see them through a severe economic shock. The exams were undermined by failing to imagine a sovereign default. Forcing banks to disclose their government bond portfolios, however, gives investors the power to conduct their own more rigorous assessments.

The official tests fell short in two important ways. First, regulators used Tier 1 capital to assess balance sheet strength, clearing any bank that had a ratio of more than 6 percent after a two-year economic shock. But Tier 1 capital, which includes hybrid debt and other non-equity instruments, has been widely discredited. Investors no longer trust it, while regulators are trying to agree a tougher definition of capital.

The second, and bigger, failing was the way the tests handled sovereign debt. Despite concerns about the finances of Greece, Spain and other euro zone countries, banks were not forced to withstand a hypothetical default. The compromise regulators devised was to assume a sharp widening of government bond spreads.

This test, however, only affected portfolios that are marked to market. The vast majority of banks’ government bonds are held in so-called banking books, which only must recognize a loss in the event of a default. As a result, all but one of Greece’s banks passed the test, despite huge holdings of their own government’s debt.

At least what the tests lack in severity they make up for in disclosure. Banks were asked to spell out their holdings of EU government bonds, and to specify what proportion is held in banking books. It is up to individual lenders to release that information, but with the exception of a handful of German banks — including Deutsche BankĀ  — most have already done so.

This information will allow investors to make up their own minds about the sovereign risks on the banks’ balance sheets. Those institutions deemed too risky will probably find it hard to access funding unless they raise more capital. And banks are bound to find the market’s stress tests tougher than the one they just completed.

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Once the first country takes the difficult decision of defaulting, the second and third countries will find it easier to follow course.

Effective stress tests must simulate the likelyhood of multiple countries defaluting.

Posted by Rajeah | Report as abusive