Credible EU bank tests need a higher pass mark

October 6, 2011

By Peter Thal Larsen
The author is a Reuters Breakingviews columnist. The opinions expressed are his own.

Europe’s banks may need to re-sit their summer exam. Regulators are looking for ways to inject more capital into the region’s troubled lenders. One potential quick fix is to use the same data as in July’s discredited stress tests, but impose haircuts on sovereign debt. But this wouldn’t be enough. The authorities should also raise the minimum capital ratio that banks need to clear.

The flaw in July’s tests was that banks did not have to mark down the government bonds they currently hold at face value. As a result, only eight of the EU’s 90 largest lenders flunked the exam, with a capital shortfall of just 2.5 billion euros. Since then, worries about sovereign debt have spread from Greece and Portugal to Spain and Italy, threatening a systemic crisis.

Ideally, regulators would conduct another test. But that would take months, and Europe does not have the luxury of time. An alternative is to re-run the tests with the same data, while forcing the banks to mark all sovereign bonds to current market prices.

In that scenario, 18 banks would fail, with a capital hole of 40 billion euros, according to Breakingviews’ stress test calculator. But that would not be enough to restore confidence. The International Monetary Fund puts the capital shortfall of European banks at between 100 billion and 200 billion euros. Some analysts have come up with even higher numbers.

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