Placebo effect?

The European Banking Authority is set to reveal the results of a second round of bank stress tests on Friday, following a first round of tests performed last year.

The first set of tests was dismissed by many market players for not being tough enough. Their failure was highlighted by the fact that all the Irish banks were given the green light, only for news to emerge a few weeks later that they had brought the country to the brink of ruin. As a result, many observers were not expecting much from the second round.

The European Banking Authority (EBA), eager to avoid accusations of irrelevance, have set far more stringent conditions for the second set of tests.

Key figures from 91 European banks have been analyzed, accounting for about 65 percent of the European banking sector and at least 50 percent of each domestic banking industry. The idea is to test how the banks would react to a hypothetical collapse.

A (hypothetical) storm is coming

The hypothetical scenario this time round is far more serious than in the 2010 tests. Banks must show they can maintain adequate resources to absorb unexpected losses in the following scenario: the economic performance of the European Union collapses by 4 percent, stock prices fall on average by 15 percent, unemployment rises by 10 percent and the real estate market posts losses of 10 percent.

For a bank to pass the test it needs to weather the storm and come out at the end with an equity ratio of 5 percent. Here, too, the bar has been raised, as the definition of an equity ratio - essentially the risk buffer from a bank's own resources - is this time much narrower.

So what happens if a bank fails the test? "At first nothing, because these banks all meet other regulatory standards," Hans-Peter Burghof, professor of banking and financial services at the University of Hohenheim, told Deutsche Welle.

"But the bank would have to do something in order not to lose the confidence of capital markets. In general, that means raising more capital," he added.

Disclosing risks

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.

Each bank was asked to fill in a 10-page form, specifying on four of these pages which loans and bonds they hold. This includes the country of origin and specific details, broken down by amount and maturity.

In response, German banking associations wrote an angry letter of protest to Brussels, saying such full disclosure leaves banks vulnerable to speculation by third parties.

"I think this is a very real danger," said Burghof. "By disclosing dependencies, other people will be able to take advantage of the information. So transparency is not always good, per se."

One thing is certain - the new stress tests will make a stir. Early estimates of the number of banks that might fail run as high as 15, compared to the seven that failed last year.

The stress tests were designed to bring more transparency and therefore invite more confidence in the financial services industry. But Burghof is not convinced. "The idea that through stress tests you can communicate to people that everything is good - no one's that naive any more."

Author: Rolf Wenkel / cb (AFP, Reuters)
Editor: Martin Kuebler