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European Banks Face New Stress Tests

Thursday, 16 Jun 2011 | 12:20 PM ET

The top European banking regulator has told European banks to stress their portfolios for "more conservative" assumptions about the value of the debt of sovereign governments and financial institutions on the continent, according to a source familiar with the instructions.

CNBC has learned that the newly formed European Banking Authority sent instructions to the banks last week ordering such securities in the hold-to-maturity portfolios to be reviewed with assumptions about possible downgrades. Those assumptions are expected to be in-line with those of an average of the credit ratings agencies. In some cases, especially for the credits of the most troubled nations, the assumptions include the possibility of further downgrades.

At least for some banks, the result is likely that they will have to increase loss provisions. Banks will have three months to conduct the stress test and an additional three months to raise loss provisions. Results will be made public, but it is unclear when.

The new instructions come amid a new flare-up in the Greek crisis that raise questions about the value of sovereign debt carried on the books of the banks. (Such securities held in the trading book are marked to market daily, but not those in the hold-to-maturity portfolios.)

The new stress test effort, while obviously tied to recent events, seems more tied to an effort by the EBA to create more believable stress tests than Europe has so far. Past efforts have been criticized in part because they failed to put what market participants thought were realistic values on the sovereign debt.

The new stress testing of European banks will be paired, according to the source, with a peer review. Regulators will attempt to ensure that similar banks are placing reasonably similar valuation on similar holdings and that loss provisions are in line with each other.

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