Stress tests due to be released in the month of July are unlikely to reveal the true extent of possible insolvencies among European banks, according to policymakers and financial analysts.
The test results will likely give banks a pass or fail grade but they will not show exactly how close a bank could be to default in certain scenarios, like a worsening sovereign debt crisis, argue the advisers.
"Some scenarios that should be included will not be included, at least in what will be publicly revealed, which will be sugar-coated to avoid market panic," according to an informed source close to policymakers.
"Under some scenarios European banks would come out bankrupt, and of course they are not going to publish that," the source added.
It is unclear whether the tests that are made public will include possible losses on sovereign defaults in Greece, Portugal or Spain, though these will probably form part of the exercise.
"Policymakers decided to disclose stress tests without realising the full implications," argues Nicolas Veron from the Brussels-based Bruegel think-tank.
"They are running the risk of enhancing, not suppressing, market uncertainty if they do not provide the information that the market is concerned about," Veron added, referring to the sovereign debt crisis.
Draft tests have not included realistic scenarios, like a considerable drop in real estate prices in some European countries, alleges another source.
EU officials announced last week that the number of banks that would be subject to a stress test exercise will be widened from the 22 big banks that took part last year to include a further 60 to 120 banks.
"There is not a whole lot of point doing these tests as the methodology and the transparency is not going to be robust," argues Kevin Newman, a European financial policy analyst.
"You only have to look at the amount of liquidity the ECB is giving banks to know that large swathes of the European banking sector are in danger of becoming insolvent," Newman added.
Threat of Greek default
Newman also argued that the likely insolvency of Greece by the end of the year meant that the tests could not possibly paint a pretty picture of the sector.
"We cannot rule out that Greece could go bankrupt before the end of this year and that it is increasingly likely that we are looking at a restructuring of debt for sovereign bond holders."
Greece is going back to the bond market on 13 July to refinance its short-term debt and if that goes badly, there could be another chain reaction on markets.
Ideal scenario is to come clean
Banks that have been hiding their losses for two years now should ideally just come clean as insolvency may be inevitable for some who have a lot of debt tied up in Greek sovereign bonds, Newman continued.
Both the IMF and the ECB have been urging banks to disclose their losses since the onset of the crisis.
Stress tests by their nature are a theoretical and abstract exercise, Newman added, arguing that investors would do better to collate information from the Bank of International Settlements (BIS) and the European Central Bank's Financial Stability Review to get a true picture of the extent of losses.
German banks are Europe's most exposed to bad loans, according to a study published last week by PricewaterhouseCoopers.
The balance sheets of Germany's banks in 2009 were laced with about €213bn in non-performing loans, a 50% increase over 2008, according to the study.
Meanwhile in the UK, banks may be able to hide behind the safety of a law which would require their consent for the publication of stress tests.
The UK banking supervisor cannot reveal confidential information without the consent of the person from whom the regulator obtained the information, according to the 10-year old Financial Services and Markets Act.
"Subject to any legal considerations, we're working" with the Committee of European Banking Supervisors "to find the appropriate level of disclosure," Heidi Ashley, a spokeswoman for the FSA, told reporters this week.