EU Regulators Planning More Robust Stress Tests

European banking regulators are preparing to introduce a “near fail” category into the new stress test process as part of a mechanism to force recapitalizations on weaker banks.

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The European bank stress tests of a year ago saw all but seven of the 91 banks in the exercise pass a 6 percent tier one capital threshold, a measure of financial strength.

But their credibility was called into question when two Irish banksthat had passed the test had to be bailed out only four months later.

This time, the tests, being administered by the new European Banking Authority, which replaced the Committee of European Banking Supervisors, will be designed to be more robust.

The EBA said last week that it planned to test the banks against both a baseline and an extremely negative macroeconomic situation, as well as country-specific shocks on property prices, interest rates and government borrowing.

Details of those scenarios, and the methodology by which they will be applied, are to be made public in coming weeks, following discussions with the banks and national regulators.

The actual testing is due to begin next month, with the results set to be made public in June.

Recognizing the shortcomings of last year’s exercise, Andrea Enria, new chairman of the EBA, told the Financial Times he was determined to make the exercise more credible – and to use it as a trigger for a thorough recapitalization of Europe’s weakest banks.

“What I would very much like to see is not a simple pass-fail outcome to these tests – if you pass, nothing to be done, if you fail, you have to raise capital by that amount,” Mr Enria said.

“It would be nice to have supervisory actions also for banks that have maybe passed the test, but are very close or have other areas of concern.” As a mechanism to achieve that, he said “supervisory action might include also pressure on [dividend] distributions”.

Although the EBA does not have the powers to order a bank directly to seek fresh capital, it does have greater authority than its predecessor body to pressure national regulators to carry out its wishes.

Analysts believe the basic parameters for the test will be similar to last year’s.

It will again exclude a stress scenario for euro zone sovereign default – deemed too politically sensitive – though that is set to be a factor in a separate liquidity stress test to assess the strength of banks’ operational funding, which will not be published.

The test is also expected to stick to a definition of “tier one” capital, rather than the stricter “core tier one” – essentially just equity – which international regulators are pushing banks towards.