Upcoming stress tests on banks will be harsher than last year's, the European Union's bank regulator said Friday, although important elements of the exercise deemed crucial to the region's crisis strategy remain undecided.
Last year's tests were widely considered a failure after some banks passed, only to require bailouts weeks later. The new test will see how banks fare with an extreme deterioration in financial markets and economic activity in order to gauge where the weak links in Europe's financial system are.
The European Banking Authority said that the simulation will assume EU economic output will shrink 0.4 percent in 2011 and will show no growth in 2012 _ a 4 percentage point difference from current forecasts. That compares with a 3 percentage point drop assumed in the 2010 stress tests.
However, even though the tests' results are due to be published in June, some important elements are still up in the air.
Crucially, the bar that banks would have to jump to pass the tests _ namely the minimum capital ratio they have to maintain despite the shocks _ was still missing from the scenarios published Friday. The so-called core Tier-1 capital ratio currently varies from country to country and the EBA said it was still in the process of defining the one to be used for the tests.
It also wasn't clear how many banks would be tested this year. The EBA only said that the tests would cover a "broadly similar group of banks" as last year, when 91 banks were included, and that the banks would represent more than 65 percent of EU banking assets. In recently leaked documents the EBA said 88 banks would be tested but the number was not included in Friday's release.
The EBA faces the challenge of asserting its credibility against 27 national banking supervisors, many of whom are eager to protect the banks under their own watch. The discovery of huge capital holes in one country's banking system could not only become expensive to the national government but also make those banks vulnerable to takeovers.
The EBA has come under fire for not setting stricter shock scenarios for banks, with critics saying a partial default of a highly indebted country like Greece cannot be ruled out. However, banks will have to disclose all relevant exposure to sovereign bonds _ including those of non-EU countries like the U.S. and Japan _ which would allow analysts to run their own calculations.
Sony Kapoor, the managing director of Re-Define, a think tank that lobbies for financial market reform, said the economic shock scenario didn't go far enough.
"The worst case scenario of a 2 percent dip in growth hardly qualifies as a 'what-if' stress situation," Kapoor said in a statement. In 2009 alone, the economy of the eurozone contracted 4.1 percent.
However, he said the EBA could still make the stress tests more credible if the capital ratio required to pass is sufficiently high.
Another problem with the stress test scenarios is that they are based on rather predictable risks, which may already have been overtaken by recent developments in Japan and North Africa and their effects on the global economy and oil prices.
"These scenarios focus on the occurrence of known problems; they don't consider what kind of new problems could still come up," said Mechthild Schrooten, economics professor at the University of Applied Sciences in Bremen.
Schrooten pointed to the sharp rise in the Japanese yen following the earthquake and tsunami in Japan as an unexpected risk that could hit European banks. "We have reactions here that are entirely beyond our imagination," she said.
The bank stress tests are seen as a central part of Europe's efforts to find its way out of a debt crisis that has already forced Greece and Ireland into international bailouts. Huge problems in Irish banks were the main reason that Ireland had to seek international help.
Analysts are also concerned about the health of banks in stronger countries like Germany and France, which are very exposed to Europe's troubled economies.
EU stress tests conducted last year were widely seen as a whitewash when only seven of 91 tested banks failed, and two Irish banks that passed the tests had to be rescued soon after.
This year's scenario is based on three elements set out with the help of the European Central Bank, the EBA said: A set of shocks within the EU mostly related to the debt crisis, a negative demand shock caused by problems in the United States, and a drop in the value of the dollar.
These developments would trigger increased unemployment and a decline in house prices, which would both hurt banks' chances of getting loans repaid.
For the eurozone, the shock scenarios foresee an average increase in long-term government bond yields of about 0.75 percentage points, with the interest rate for German bonds remaining stable. On top of that, stock prices would drop 15 percent under the scenario.