European Stress Tests Lacking in Details


The devil is in the detail, or lack thereof, for the European bank stress tests.

The results of the tests will be released Friday, which could affect both the European and US markets.

But there are major differences between the tests used in the US in 2009 and those being employed in Europe now. Analysts say the comparisons aren't looking favorable for Europe largely because of what we don't know about the tests on the continent.

What we know is that the US stress tested its 19 biggest banks, while Europeans will test 91 banks, a much larger and unwieldy group that involves the work of around 20 separate national bank regulators. In the US, four regulatory bodies were involved in designing and testing the banks, largely led by the New York Federal Reserve bank.

The European banks' portfolios will be tested under an assumed decline in GDP (gross domestic product) of 2 percent this year and 1.5 percent next year. Those numbers are on par with US assumptions, which looked for a 3.3 percent decline in GDP the first year, 2009, and a rise of 0.5 percent this year.

Whereas critics of the US bank stress tests complained that there were too many details, the concern about European tests is that there are too few.

For example, US regulators told the public what assumptions it was making for unemployment and housing price declines—a key component since so many of the perceived problems on the banks' books were real estate-related.

US regulators also laid out a program for how banks could fill whatever shortfalls in capital the stress tests revealed. Critics of the European tests see a lack of transparency and little clarity about funding should banks fail.

Some countries have made public a funding mechanisms if banks can't raise private capital, others haven't. Apparently, nations that have trouble funding their own bailouts can access a program from the International Monetary Fund (IMF), but the route to getting that money is unclear.

The fear is that capital holes are revealed to markets, but no fix is apparent.

Another issue: A big part of what ails European banks is the sovereign debt held on their books. But no one knows what discounts will be applied to those debts, which markets have already deeply discounted.

“It looks like the sovereign stress test will assume only a modest decline in bond prices that are judged to be temporary and which have only a moderate impact on the real economy,” wrote Bruce Kasman of JP Morgan Chase .

Kasman believes that most European nations will be able to finance their banks if capital shortfalls appear, but agrees that it's unclear how a country would access the special IMF fund.

Barclays said last week that the European stress tests could result in positive news, but added, “There are not enough details.”

Some contend that the US tests ended the bank panic by showing investors that bank capital was in better shape than they assumed and would remain adequate under a pretty tough set of economic assumptions. It also said banks with capital shortfalls could access the Troubled Asset Relief Program (TARP). All of that led to rallies in bank shares and capital raising of almost $120 billion.

Such a definitive and positive outcome from the European effort is anything but assured.

(CORRECTION: This version of the story makes clear that banks in 20 European Union countries will be tested, not just those in the euro zone)