Stress Tests Assume No Sovereign Default Risk

Results of stress test on 91 pan-European banks will be released Friday. A bank fails the test if its Tier-1 capital ratio is below 6 percent under two scenarios: adverse scenario and adverse scenario plus sovereign risk.

The Committee of European Banking Supervisors (CEBS) said the tests were tougher than the ones carried out in the US last year, because its adverse scenario is so severe that it is a once-in-20- years possibility, while the US one was considered a one-in-seven-years possibility.

The euro

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[EUR=X  Loading...      ()   ] fell sharply after the release of the methodology, as investors still doubt that they will reflect the full extent of the financial sector's woes.

Here are details of the methods and criteria applied in the tests:

ADVERSE SCENARIO:

-  Gross domestic product (GDP) 3 percent deviation on average, taking into account the European Commission's forecast of around 1 percent GDP growth for 2010 and 2 percent in 2011

- A 6 percent increase in unemployment

-  A 6 percent rise in markets' interest rates       

- Currency swings

- Banking book equity value drop of 20 percent in 2010 and 20 percent in 2011 (cumulative effect of 36 percent) and securitization external ratings downgrades of four notches

- House prices variations (which will be calculated by national authorities in each country)

SOVEREIGN SCENARIO:

-  No default applied

- Starting point is the value at the end of 2009

-  Haircuts were applied to all EU government bonds (even Germany - 4 percent for a 5-year bond)

-  Haircuts were applied to trading books only

-  Portuguese 5-year bonds haircut: -14 percent

- Germany 5-year bond haircut: - 4 percent

- A 10-year Greek bond would have a 42.2 percent haircut if a long-term interest rate that was 5.77 percent at the end of 2009 would surge to 14.69 percent at the end of 2011.

-  In this case, a 5-year Greek bond would see a fall in value of 23 percent.