• Video
• Image

Bank stress tests revive confidence

The stress tests are designed to see if Europe's banks have enough capital reserves to survive another crisis Source: Bloomberg

Hypo Real Estate in Germany and five regional lenders in Spain were among those deemed to need increased capital.

European governments are expected to move fast to announce how they will shore up the banks which have failed the tests, and can now expect to face redoubled problems in raising funds normally from financial markets.

Governments could do this either directly or through national bank recapitalisation.

Some banks are already being helped by exceptional measures by the European Central Bank, including the purchase of some government bonds.

The tests were intended to remove clouds of suspicion and uncertainty about the true state of many banks in Europe, and therefore the risk of a lack of confidence causing a domino effect.

It is the first time that such an insight into the secret entrails of leading banks, individually and collectively, has even been published in Europe.

But the key findings are only half the story. Analysts and investors in financial markets are highly suspicious of the rigour of the criteria used for these crash-tests of the ability of banks to withstand a shock.

Prior to the release of the results, analysts said the key question on the minds of investors would be: were the tests tough enough to convince skeptics that the banks in question are really sound?

The broad principles of the criteria are known. But if markets judge the details of the tests to have been too weak, they have warned that the result could be to undermine or even negate the objective of the examination which is to remove uncertainty.

If the criteria pass the market test, then doubts about the solvency of the European banking sector will be dispelled. Banks will step up lending among themselves and, more importantly, to businesses and the economy at large.

"If the stress tests are seen as weak then they would lose their credibility and if they are too harsh then the currency markets could be spooked, making a fragile situation even worse," noted analyst Viv Jemmett at Bell Pottinger.

"If the tests are seen as transparent, then the credit markets that have remained locked down for many European banks could start to reopen.

"But if the market views the stress tests as simply a 'smoke and mirrors' exercise then things could get a lot worse for many European financial institutions."

A key testing yardstick is a bank's Tier 1 ratio, which measures core capital against total assets, such as outstanding loans.

Banks must maintain a minimum ratio of 6.0 per cent while a surplus reassures investors the bank is not likely to find itself suddenly strapped for cash.

Another important issue is a bank's vulnerability to potentially heavy losses on loans and sovereign bonds issued by certain eurozone member states.

In general the tests were designed to show how each bank would cope if economic growth slowed sharply, if money owed were not paid, if stock markets plunged or if there were crisis that slashes the value of government bonds on their books.

The bottom line of the tests is how the balance sheets of the banks would look once they had been adjusted for the effects of such shocks - in other words, would they have enough capital to continue operating.

In administering the tests in each EU member state, regulators included banks, in descending order of size, to cover at least 50 per cent of the national banking sector in terms of total assets.

Overall, the 91 banks tested account for 65 per cent of the business done in the EU banking sector.

The CEBS has stressed that the testing exercise was not aimed at forecasting outcomes. Instead, it was a "what if" analysis.