EU hopes stress tests boost faith in its banks

With results due on Friday, economists say as many as 15 banks might fail the European Banking Authority's tests designed to see which institutions need to strengthen their finances

Ninety European banks get their test results back Friday, as regulators seek to increase transparency and convince the markets that the global financial system can withstand big shocks like a possible Greek debt default.
The publication of stress tests by the European Banking Authority is supposed to reduce the uncertainty hobbling banking activities by showing which banks hold how much in bonds issued by Greece and other shaky eurozone governments.
While officials are downplaying the possibility of a Greek default, the exercise aims to publicly identify weak banks so national regulators can push them to strengthen their finances. That in turn could help them absorb losses and limit the blow to the overall European economy if Greece or another country eventually can't pay back all its bond debt.
Banks are a key part of Europe's debt crisis because they hold billions in bonds from financially troubled governments. A default or other losses on those bonds could hurt banks and choke off credit to businesses -- creating a credit crunch that that after the 2008 collapse of U.S. investment bank Lehman Brothers.
Estimates of the number of European banks that might fail run as high as 15, compared to only seven that flunked last year. The 2010 stress tests were widely regarded as a failure after Irish banks that passed had to be bailed out by the government by the billions only weeks later.
This time, banking regulators have been trying to walk the fine line between being tough enough to be believable and not rattling nervous markets with more bad news.
Banks must show they can maintain adequate resources to absorb unexpected losses even during an adverse scenario in which growth falls 4 percentage points short of European Union estimates in 2011 and 2012. That comes out to a fall in gross domestic product for the 17-member eurozone of 0.5 and 0.2 per cent.
The gloom-and-doom scenario also includes a fall in real estate, stocks and the U.S. dollar.
One key new measure will be detailed information on how much each bank holds of shaky government bonds from Greece, Portugal and Ireland -- by country, amount and bond.
The big question is whether governments and banks act on the results by taking painful steps such as raising capital. Asking private investors for more money can dilute shareholdings, and therefore can weigh on stock prices; banks that can't get new capital from markets may have to turn to governments.
"What we would hope is that governments come forward with clear plans to aid failing banks, or banks that are nearly failing, and so far we haven't heard much about that," said Marie Diron, senior economic advisor for Ernst & Young.
She said estimates that around 15 banks could flunk sounded right. "Most of these would be in Spain, Greece and the countries under highest pressure, but some, I would think, as well in some of the core eurozone countries and that is where governments are least ready to tackle the issue."
For the weaker banks, the test could force governments to decide to recapitalize them, either by pushing them to ask shareholders for more money or by using taxpayer funds.
That would include banks now being kept alive by emergency credit from the European Central Bank -- according to the IMF, many of the banks in Greece, Ireland and Portugal as well as some Spanish savings banks.
Healthier banks would reduce the chances of a mushrooming disaster if Greece defaults.
"Really, the necessary condition for that is that governments go ahead and deal with banks that are shown to be failing this test or are nearly failing this test," said Diron. "The publication alone is not enough." To pass, banks must show they can maintain a reserve cushion of high-quality capital -- dubbed Core Tier 1 capital -- of at least 5 per cent of their loans and bond and securities holdings.
The current test includes far more data than last year's -- some 3,000 pieces of information, as opposed to 149 -- but has raised questions about its toughness because its worst-case scenario did not explicitly include a Greek debt default.
Results were to cover 91 banks, but on Wednesday Helaba, a German bank, said it had been told by the EBA that its results would not be released since they included a form of capital not approved by the EBA.
Helaba said it and its owners, which include the German state of Hesse, had taken steps to convert the state's stake, known as a silent participation, to a form that met the EBA's requirements. It was told, however, there wasn't time to review it to make sure the change complied.
The EBA didn't respond to requests for comment on the Helaba issue.
Helaba said if the silent participations -- a form of non-voting stake -- were allowed it would have passed with a 6.8 per cent core Tier 1 ratio.