European bank stress test results raise doubts, hopes

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Only eight European banks failed to pass stress tests of their ability to withstand a new recession, with Italian banks doing surprisingly well ahead of a key EU summit on Thursday (21 July).

The European Banking Authority (EBA), which conducted the stress test, said after the market close on Friday (15 July) that eight banks failed the exercise, with a total capital shortfall of €2.5 billion.

This puny amount in European banking terms sparked a repeat of last year's accusations that the stress tests were again unrealistic given the euro zone's sovereign debt crisis.

Critics said the health check fails to reflect market expectations that Greece will default on its debt in some form, which would pile up losses for German and French banks that hold large amounts of the country's debt.

The banks that failed are small, nearly all untraded and mainly in Spain, where banking problems have long been known.

The tests revealed five banks in Spain, two in Greece and one in Austria flunked the test. Expectations were for five to 15 banks to fall short and need to raise €10 billion or more in capital.

"It was not politically palatable for the tests to consider an inevitable Greek default," said Jason Karaian, economist with The Economist Intelligence Unit. "Under a more realistic test, the actual capital shortfall is likely to be at least ten times the official estimate of €2.5 billion," Karaian said.

"The stress scenario isn't adverse enough to make the stress test really worthwhile," said Fredrik Nerbrand, global head of asset allocation at HSBC in London. "It wasn't going to show that very many people had failed."

No black Monday expected

What the report does provide is a much greater level of detail on banks' exposures than previously, which may allow investors to take a sharper judgement this week.

Few analysts and regulators expect a broad sector sell-off when markets open on Monday (18 July), while the greater transparency over sovereign debt holdings could lift uncertainty over some stocks.

EBA Chairman Andrea Enria told Spanish daily El Pais he does not expect a rout in Spanish banks on Monday.

"It's a formidable exercise in transparency, which has not unveiled any great surprises and therefore I do not expect a black Monday. Absolutely not," Enria said.

The impact of the test is likely to be twofold.

Sixteen banks scraped through the test and analysts expect them to come under market pressure to bring capital cushions up to scratch well before the EBA's April 2012 deadline.

They include Spain's Bankia – which is planning to list on Wednesday – Popular, Sabadell and four more Spanish banks, Italy's Banco Popolare, Greece's Piraeus and Cyprus's Marfin.

Portugal's biggest bank Millennium bcp also nearly failed, and it set the tone for swift action by saying late on Friday it would raise €400 million.

Limited value

The second main impact of the EU's third health check of banks since the financial crisis began revolves around sovereign debt holdings of countries at the heart of the problems.

"The EBA stress test result is of limited value to us as the sovereign banking book exposures are not fully stressed and it is based on a relatively low 5% [pass mark]," JPMorgan analyst Kian Abouhossein said.

"However, it offers transparency with excellent new input data, especially in respect to sovereign risk and credit exposure at risk."

Banks have warned that too much transparency, such as news of BNP Paribas' €24 billion exposure to Italy, may make markets even more jittery.

The sovereign data may come into its own later this week.

Eurozone leaders meet on Thursday in a bid to agree a second bailout for Greece and a package to address the broader fiscal woes of the euro zone that last week moved beyond Greece, Portugal and Ireland to Italy and Spain.

This broader package may include measures whereby banks agree to take a hit in some form on the sovereign debt they hold to give eurozone countries more breathing space to recover.

"The test is compatible with the voluntary approach being discussed," Enria told Reuters Insider.

Exposure to Greek debt partly revealed

The EBA data showed Europe's banks held €98.2 billion of Greek sovereign bonds at the end of December, with two-thirds of that held by Greece's banks, 9% by German banks and 8% by France's.

Banks' exposure to Irish sovereign debt was €52.7 billion (61% held domestically) and to Portugal it was 43.2 billion (63% held domestically).

This sovereign debt data has been crunched by analysts at big banks over the weekend in tests that were toughened up with default scenarios – something the EBA was barred from doing by nervous EU finance ministers.

Europe's banks would need €41 billion to keep their core capital ratio above 7%, the new global minimum from 2013 under the Basel III accord and already required by markets in practice, according to Reuters' calculations.

This compares with the 5% pass mark in the test.

JPMorgan's Abouhossein said a tougher test of 27 of the bigger banks using EBA data would show 20 are a combined €80 billion short of capital.

His test applied a haircut to sovereign bond holdings in the banking book and required banks hold core capital of 7%.

Credit Suisse analysts said applying larger haircuts on peripheral eurozone bond holdings, including for Italy, as per current market prices, would leave a €45 billion deficit for 49 banks it tested.

Without market pressure, some banks may not top up capital levels as some local supervisors dispute test conclusions.

Germany's Helaba pulled out of the test just before the results were announced, disputing it would have been failed. The Bundesbank said it was happy with Helaba's capital position.

In Spain, the central bank says no lender needs to raise capital.

EURACTIV with Reuters

"The stress test results were in line with leaked guidance and market expectations. Nonetheless, they are unlikely to be trusted or stabilise confidence in those banks which need it most, i.e. banks which are currently unable to fund themselves in wholesale markets at affordable costs," said Georg Grodzki, head of credit research at Legal & General investment management, London

Richard Cookson, global chief investment officer at Citi Private Bank, London, said: "Even with stress tests that are extraordinarily limited in their scope because they don't actually include the possibility of default, which seems a little peculiar given that's what policymakers are talking about at the moment, a number of the banks are either borderline or have failed so I don't really think these tests amount to a row of beans in themselves."

"The way to think about them is they put some more information in the public domain, but that's going to be still fairly limited. And given what we've seen in the peripheral bond markets in the last couple of weeks, they are out of date, even before they were released."

Markus Huber, head of sales and trading at ETX Capital, London, said: "As already widely publicised, many experts considered the criteria applied for the test, like a decline of 15% in the stock market and a negative eurozone growth of 0.5%, as insufficient and not realistic enough."

"Especially as things like a potential Greek default, which has not only become a real possibility in recent weeks but which has been dominating the headlines and market actions for many months now, has been omitted from the test."

"In light of this, the results are not really that relevant. It stands out that all Italian and Portuguese banks have passed the stress test. The market takes it in a positive way, partially as rumours were circulating that up to 21 banks have failed versus eight which actually did not make it [...]. But all or most of this means nothing if Greece would default and the fallout would spread to other countries under pressure especially Spain and Italy."

Géraud Missonnier, a trader at Saxo Banque, Paris, said: "All the Italian banks have passed the test. This is reassuring for the euro zone, and the overall number of banks that have failed the test seems somewhat lower than what the market had been expecting. Overall, we don't see much impact from this on the equity market, it's been priced in already."

The bank stress, conducted by the European Banking Authority (EBA), made 90 lenders reveal for the first time their profit forecasts, a breakdown of their sovereign bond holdings and funding costs, forcing the weakest to recapitalise.

The EBA says the adverse scenario used for its test is more severe than last year on a number of criteria. Its baseline assumption is the autumn 2010 European Commission's forecast.

The test assumes a fall in the price of government bonds, which will be applied to assets in trading books. These "haircuts" will apply to their fair value at the end of 2010.

The haircut for 10-year sovereign bonds is 19.8% for Portugal, 14.6% for Spain, 13.1% for Italy and 3.5% for Germany.

Each country should have a backstop plan in place before the results come out to recapitalise banks that fail.

Failing banks will be given a deadline to recapitalise.

  • 21 July: Eurozone heads of state meet in Brussels to agree new aid package for Greece.

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