The EU will disclose the results of the stress tests it is conducting on the 91 banks within the EU tomorrow. Lenders accounting for 65 percent of the EU banking industry will be tested, including 14 German banks, 27 Spanish savings banks, six Greek banks, five Italian banks, four French banks and four British banks, according to the Committee of European Banks Supervisors (CEBS). CEBS’s role is to coordinate national banking authorities and make policy recommendations to the EU on regulation.
The results are expected to show how individual banks would hold up to economic and market shocks. Policy makers haven’t decided yet on the level of detail to disclose.
So, what are the stress assumptions?
The test assumes a 3 percentage point deviation from the European Commission’s economic forecasts over two years and a deterioration of sovereign debt risk as compared to market prices in early May, said. The Commission estimates the EU’s economy will grow by 1 percent this year and 1.7 percent next year.
In contrast the US stress test conducted last year assumed a “more adverse” scenario of the economy shrinking by 3.3 percent in 2009, while unemployment would rise to 8.9 percent. They also assumed the U.S. economy would grow 0.5 percent the following year, while the jobless rate would surpass 10 percent. The tests didn’t include a measure of the impact of a drop in sovereign debt.
The key measure for determining which of the 91 banks being tested will need more capital is whether they could maintain a 6% Tier 1 capital ratio under the loss assumptions imposed by the test. That's the same level that was required in the stress tests of U.S. banks, though that is where the similarities between the two tests end.
The U.S. stress tests carried out last year found 10 lenders requiring to raise $74.6 billion of capital.
Is the severity of the Eu stress test good enough?
Well, not according to the many market pundits. Regulators have asked the lenders to assume a loss of about 17 percent on Greek government debt, 3 percent on Spanish bonds and none on the German debt.
Some are commenting that ‘This isn’t a stress test and is merely the current valuation of government bonds’. Credit markets are pricing in losses of about 60 percent on Greek bonds should the government default, more than three times the level said to be assumed by CEBS. Derivatives known as recovery swaps are trading at rates that imply investors would get back about 40 percent in a Greek default or restructuring.
Will the results be credible enough to restore confidence?
EU regulators are relying on the stress tests to restore public confidence in banks amid concern that some lenders don’t have enough capital to withstand a default by a European country. A stress test of U.S. banks last May spurred a rally that lifted the Standard & Poor’s Financials Index by 36 percent in the following seven months. EU regulators are hoping for a similar result.
It is not clear what level of disclosure is going to be provided. Is likely that details will only be available in cases where if they have something negative to say will be when there is already a solution in place. This is unlikely to providing much needed market confidence.
For e.g. - Spain's unlisted savings banks -- known as cajas -- have been hit hard by real-estate related losses, forcing the recent seizure of CajaSur by the Bank of Spain. Regulators, however, are testing the cajas as though extensive mergers planned for the sector had already taken place.
A string of banks failing the European Union's stress tests could be one of the strongest signs the process has been a success, but analysts fear the tests could end up being a damp squib, offering too little information to boost confidence.
Overall, concerns over the severity of tests, the level of disclosure and the willingness of regulators to force more capital on banks have left many observers skeptical they can make a real difference.
Who will be the winners and losers?
The problem is that a steady drip of leaks and optimistic predictions from lenders, central bankers and politicians all suggest that the vast majority of banks in even the most troubled economies are likely to pass.
In recent days, Luxembourg Prime Minister Jean-Claude Juncker, French Finance Minister Christine Lagarde, Greek Finance Minister George Papaconstantinou, Irish central bank governor Patrick Honohan and his Italian counterpart Mario Draghi have been just a few of the officials to express confidence that their banks will pass the tests. "There are very few left to fail”.
Some of the banks that are likely to show need for additional capital include Hypo Real Estate, Commezbank, Deutsche Postbank in Germany, Sabadell in Spain and Banco Popolare in Italy .
So, is market then running ahead of itself?
The cost of insuring against losses on bonds issued by Europe’s banks and insurers fell to the lowest in a week yesterday on expectation of successful stress tests. The euro has rallied 8 percent from a four-year low last month. Greece, Spain and Portugal have managed to sell 50 billion euros ($64 billion) of debt since May 10, when the need to save the single currency forced finance ministers to create a nearly $1 trillion rescue fund and European Central Bank President Jean-Claude Trichet to begin buying bonds.
The extra yield investors demand to buy Spanish and Portuguese bonds instead of comparable German securities declined after debt sales this week and those spreads have narrowed 24 percent and 19 percent respectively from euro-era highs in May. The market seems to be much more convinced following the bailout that the euro zone is working and the peripheral countries will be able to finance their debt.
From this market reaction one could conclude that Europe may already have passed its biggest stress test.
…but we are not out of the woods yet…
“We are not the Titanic, but let’s not fool ourselves into thinking we are safe just because we have first-class tickets,” Italian Finance Minister Giulio Tremonti said July 20 at the University of Fribourg, Switzerland.
Pushback against austerity in Hungary highlights the risks for euro-region countries. Talks between Hungary’s two-month-old government of Viktor Orban, the EU and International Monetary Fund broke down this week, delaying payments from a 20-billion euro aid package. The standoff sent the forint to a 14-month low on July 19. Workers in Spain, Portugal and Greece have taken to the streets to protest against the budget cuts that include higher taxes and lower wages for civil servants, typically the core supporters of the socialist parties that rule all three countries.
Greece, which triggered the crisis with the revelation that its deficit was more than four times the EU limit, is trying to trim the shortfall to 8.1 percent of gross domestic product this year, from 13.6 percent last year. Spain’s shortfall reached 11.2 percent last year with Portugal’s at 9.4 percent. None will return to the EU’s 3 percent limit before the start of 2013.
Even if Greece achieves its deficit-cutting goals, the country’s debt is forecast by the government to peak at almost 150 percent of GDP in 2013, a level that may require a restructuring.
“We’re not out of the woods by any means,” said Nixon, a former ECB economist. “We’re dealing with a long-running, multi-year problem. You can have a good year, but you have to come back and do exactly the same next year and the year after.”
...so, will it be Eustress or Distress?
Markets are likely to remain nervous until the results are known tomorrow but the outcome will be "nothing but a damp squib," according to many market participants.
Unlike in the United States, we believe that the E.U. stress test is unlikely to restore confidence to underpin a strong share price rise. It may well end up not delivering either the Eustress to the market or the expected level of distress to the banks under review!
One more day and we will know………!