EU hopes stress tests boost faith in banks

AP News
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Posted: Jul 14, 2011 3:29 PM
EU hopes stress tests boost faith in banks

European regulators will release potentially unsettling details on the finances of 90 banks on Friday to increase transparency and convince markets that the financial system as a whole could withstand big shocks, such as a Greek debt default.

The publication of the results of the stress tests by the European Banking Authority is supposed to reduce the uncertainty hobbling bank's activities through disclosure of details including who holds how much in bonds issued by Greece and other shaky eurozone governments.

While officials are downplaying the possibility of a Greek default, the idea of the exercise is 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 European economy if Greece 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, as happened after the 2008 collapse of U.S. investment bank Lehman Brothers.

Estimates of the number of banks that might fail run as high as 15, compared to seven that flunked a version of the tests done last year. That exercise was widely regarded as a failure after Irish banks that passed had to be bailed out by the government 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 percent.

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 in coming months 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 be the occasion for 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 that are being kept alive by emergency credit from the European Central Banks _ 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 percent 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 in part because its worst-case scenario did not explicitly include a Greek debt default.

The agency finessed the default issue by asking banks to set aside reserves to cover risks on troubled government bonds but isn't outright calling it a default scenario.

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, that there wasn't time to review it to make sure the change complied.

The EBA didn't respond to reporter calls and emails on the matter.

Helaba said that if the silent participations _ a form of non-voting stake _ had been allowed it would have passed with a 6.8 percent core Tier 1 ratio.

(This version CORRECTS Corrects paragraph 20 to indicate state of Hesse is not sole owner. Overall results to be released by European Banking Authority at 1600 GMT (1200 EDT) Friday, with banks reporting individually. EBA expects then to publish full results at 1630 GMT.)