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Will Europe's Stress Tests Be a 'Missed Opportunity?'

European banking stress tests will be a missed opportunity for policymakers to reassure markets that they are capable of formulating a meaningful response to the sovereign debt crisis, unless they come down heavily on undercapitalized banks, analysts and investors told CNBC.com.

European Central Bank
European Central Bank

The European Banking Authority, an agency created to oversee the tests, will release its 2011 results on Friday.

The stress tests examine the integrity of 91 banks, accounting for around 60 percent of the continent's total banking assets. Publication of the results of the 2011 test – the second time the industry has gone through the process – was initially due in mid-June, but was pushed back by a month.

Last year's stress tests were heavily criticized for being too lenient and for being inconsistent across the continent. The most severe scenario tested in 2010 was that of a moderate recession with some losses on sovereign credit.

This year, as well as putting in place a capital benchmark of 5 percent, the stress tests will examine banks' resistance to an "adverse scenario" which includes a set of European shocks and slowdowns in Europe and the US, as well as a fall in the US dollar and in real estate prices.

Even so, with a sovereign debt crisis in full swing, market participants are not anticipating that this year's tests will prove sufficiently rigorous. CNBC.com spoke to a number of investors and analysts who remain unconvinced by the exercise.

"I think the surprise would be if the stress tests were serious and not just a fudge. The broader issue that euro zone policymakers have is that they have lost the confidence of the markets, and it's crucial that they regain that," Carl Astorri, global head of economics and asset strategy at Coutts, told CNBC.com.

"The euro zone crisis is, at its heart, a banking crisis rather than a fiscal crisis, so this is an opportunity for policymakers to get ahead of the market, but everything that they've done so far suggests that they won't use that opportunity."

John Ventre, portfolio manager at Skandia investments, agreed.

"It doesn't seem to me that these are stressing the right thing. So while they are stressing sovereign spreads widening, they are not explicitly stressing a sovereign default, which is what the market is worried about, and they're not really stressing the interconnectivity of the system – what happens in the event of a big dent in confidence as a result of a sovereign default or sovereign event, and they're really just testing single country sovereign spreads and economic slowdown," Ventre said.

As a number of fund managers and analysts told CNBC.com, the market will not be reassured by a large number of banks passing the tests. If policymakers believe that rubber stamping institutions that the market thinks are undercapitalized will reassure investors, they may be in for a surprise.

A very harsh set of stress tests, where many fail, coupled with realistic plans to recapitalize them, would be far more reassuring to the market, Ventre said.

"At least those who don't need to recapitalize walk out with a clean bill of health, whereas this process might just leave us all still wondering about our counterparty, and really that's how financial crises get caused, not actually by weak balance sheets, but by people worrying about the state of their counterparty, of their competitors' balance sheets. The worry is as pervasive, if not more so, than the reality," he explained.

On Wednesday, Mario Draghi, governor of the Bank of Italy and heir apparent at the European Central Bank, said in a speech that he was certain that Italian banks would pass the stress tests. On Tuesday, the Spanish newspaper ABC reported that as many as six of the country's banks had failed.

As many analysts have pointed out, Europe's crisis is as much a banking problem as it is a sovereign debt one. A default in the periphery would transmit losses to the banking system continent-wide, and government commitments to recapitalize failing banks will put further strain on already depleted government resources. Were the Spanish government to need to find further funding to fund a state-led recapitalization of its banks, it may struggle to raise it at sustainable yields, deepening its own worries.

This is why the stress tests could have been significant, analysts said. By pushing the banks to recapitalize for the event of a sovereign default and coming up with the funds to help them do so, policymakers could have vaccinated the banking system against the inevitable crystallization of their losses on peripheral country debt.

Once banks are recapitalized, measures to reduce the debt of overburdened countries – i.e. technical default – could be taken, dealing with a mounting solvency problem in those countries.

This is a quite urgent priority, as Italy, Europe's fourth largest economy, looks increasingly likely to be drawn into a debt crisisthat was previously reserved for smaller, peripheral nations, according to Coutts' Astorri.

"Quite quickly, you're getting into a situation where you need a solution to the solvency problem, because the market is pushing the solvency problem into areas where there isn't enough money to solve the problem," he said.

Several analysts floated the idea of using the European Financial Stability Fund, created in 2010 to shore up government finances in weaker economies, to recapitalize banks. Others said that regardless of the technicalities of a solution, European leaders needed to take chances like this to show clarity of purpose and the ability to take difficult decisions.

"It's not impossible but it takes great political vision and leadership and courage, and that's something that's been lacking and is why the crisis keeps rolling on," Astorri said. "That hasn't been there up until now. This is an opportunity for those qualities to be exhibited, but I rather doubt that they are going to be."