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ECB sets tests to strengthen Europe’s banks

The euro zone's banks look set to try and raise more funds to help them meet stricter laws and capital limits, as the European Central Bank (ECB) prepares to take on the role of the region's banking watchdog.

The future of the euro zone's banks will be shaped by the new ECB rules, announced Wednesday morning. The region's most important banks will have to undergo an assessment of their risky assets, the quality of their balance sheets, and the amount of capital they hold.

Under the new regulations, euro area banks will have to hold capital equivalent to 8 percent of their risk-weighted assets to protect them from further economic shocks. The ECB had been expected to only enforce the 8 percent requirement with the biggest banks, with a 7 percent level for smaller players.

(Read more: Stressful times for Europe's banks)

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ECB President Mario Draghi said: "A single comprehensive assessment, uniformly applied to all significant banks, accounting for about 85 percent of the euro area banking system, is an important step forward for Europe and for the future of the euro area economy. Transparency will be its primary objective. We expect that this assessment will strengthen private sector confidence in the soundness of euro area banks and in the quality of their balance sheets."

The stress tests are a key part of the journey towards banking union – the EU's attempt to strengthen the region's financial industry so that governments no longer have to step in and rescue them. The union will include a central system to manage the demise of bust banks, a deposit insurance scheme and a single banking supervisor, which will be run by the ECB.

(Read more: Which European banks failed the last stress tests?)

The ECB will begin its assessment as it takes over supervision of the 128 most "significant" euro area banks from the second half of 2014.

A raft of European banks are expected to have to raise capital between now and October 2014 to ensure they meet the capital requirements. Bank of Ireland is expected to be one of the first, with Irish press reports suggesting it will try to raise capital before the end of the year.

While this refunding is likely to mean shareholder dilution, it is also necessary to improve the banks' credibility, its proponents believe.

French-Belgian bank Dexia, bailed out three times despite passing stress tests in 2011, is a salutary reminder of the criticisms leveled at previous tests.

(Read more: The aftermath of Dexia's bailout)


Bank chief executives have been bullish in public about the stress tests. Christian Clausen, chief executive of Nordea, told CNBC Wednesday that he welcomed the tests and hoped they would give more transparency.

Yet European banks' share prices – including Nordea - fell across the board Wednesday morning after the ECB outlined its stress tests, while the euro also fell slightly against the dollar. This suggests the markets are not as optimistic about the banks' health as their chief executives.

"The stress tests will be conducted amid a shift from a bail-out to a bail-in regime for Europe's vulnerable banks and when there is continued uncertainty about the necessary backstops," Nicholas Spiro, managing director at Spiro Sovereign Strategy, warned.

"There's a danger that eurozone policymakers are putting the cart before the horse."

There was some relief that the banks would not have to meet higher capital requirements, at the start of the assessment next month.

And some analysts argued that the banks have improved since the days of the credit crisis.

"The operating environment looks to us to be less hostile than in recent times and much hard work has been done on balance sheet improvements," Nigel Myer, director of credit strategy at Lloyds, said.

Yet fundamental concerns remain over the "debt spiral" linking higher government exposure to weak banks, the health of banks themselves and weak economic growth will be difficult to break.

"It doesn't matter how stress-tested and well-capitalized you think peripheral bank ABC is, if you think the sovereign is going to need a PSI or will default, then the bank is uninvestable," Neil Williamson, head of EMEA credit research at Aberdeen Asset Management, said.


- By CNBC's Catherine Boyle. Twitter: @cboylecnbc.

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