Europe Economy

Questions Raised Over Banking Stress Tests

After the European market closes on Friday, global markets will be digesting the results of the latest set of stress tests for European banks. Those that fail will need to raise more capital and the health of those that pass is likely to remain in doubt given questions being raised about the credibility of the tests.

About a month ago, the European Banking Authority demanded that Europe’s banks resubmit their data to reflect the stresses facing the euro zone, if not an outright default by a euro zone government.

On Friday Moody’s said that this will undermine the credibility of the tests. “The credibility of last’s year EU test was diminished by the difficulties faced by the Irish banks a few months after the publication of the second round of tests and because sovereign risk assumptions were considered lenient given prevailing concerns about several EU countries,” the rating agency said.

“While stricter than the 2010 European bank stress test, we note that the EBA’s 2011 stress assumptions does not assume a sovereign default at a time when the risk of a sovereign default within the euro area has increased. The test will, however, incorporate additional measures of sovereign stress aimed at reflecting, somewhat, recent market developments, which is a step that enhances the credibility of the exercise."

A paper released by the EU has called into question the ability of some member states having the funds or the willingness to step in and help re-capitalize banks that fail.

"This may affect the credibility of the overall exercise and entail serious risk for financial stability in the EU," said the EU report.

Moody’s, however, believes the 2011 stress tests will be a positive for the European banking sector despite predicting 26 of the 91 banks under scrutiny will fail.

The credit ratings agency said greater transparency about sovereign debt holdings of the banks will remove uncertainty, whilst giving regulators insight into capital positions across Europe.

“Whether the publication of test results scheduled for July 2011 will positively affect banks’ access to the financial markets, however, partly hinges upon the tests being perceived as being credible.

“If credible and rigorously applied, the stress test will provide investors with valuable information about major EU banks’ capital adequacy. If not, the test will at best be irrelevant and at worst could undermine market confidence” said Moody’s.

Analysts at UBS believe the stress tests will not be very helpful.

“The imminent European Banking Authority stress tests are considering neither funding nor liquidity, and therefore cannot offer useful conclusions on the Euro zone banking system’s robustness,” said Alastair Ryan, an analyst at UBS in London in a research note on Monday.

“The tests will offer new disclosure on sovereign exposures, but with the recent official debate over whether credit default swaps should be triggered by events that any layman would consider a default, we are concerned the market may respond to gross exposures to various sovereigns.

“We struggle to see the tests as a positive,” said Ryan.