EU bank test laggards need capital backstop

LONDON: Persistent critics of Europe's bank stress tests may have to pipe down.

Sources close to the exercise have told Reuters that up to 15 of the continent's banks one in six of those sitting the exam could flunk it.

That would give the tests a credibility boost. But it raises another problem: how to plug the resulting capital hole.

The European Banking Authority, which is overseeing this year's health check, has tried hard to raise the pass mark following last year's flop, when just seven small banks failed to meet the required hurdle.

The EBA has tightened up its definition of capital, preventing banks from counting state-supplied hybrid debt. It also forced some banks to beef up their assumptions about the possibility of a default in Greece and other peripheral euro zone countries, triggering extra provisions.

These latest moves by the EBA explain why banks in Greece, Portugal and Spain are expected to be among those failing the tests. After all, these lenders tend to have the greatest exposure to their troubled home governments.

A few may be able to raise private capital. But if banks turn to their governments for help, the risk is that they drag each other down.

Preventing a vicious spiral requires a capital backstop. Some of the countries that have already been bailed out have these: Greece set up a 15 billion euro fund to recapitalise banks last year, while Portugal's bailout has also earmarked cash to help banks.

Spain, meanwhile, has its Fund for Orderly Bank Restructuring, but its main source of funds is selling bonds to investors.

If Spanish banks need significant amounts of help, the government will have to step in directly.

It should signal its willingness to do so before the tests results are published for example by offering to underwrite capital increases for lenders that fail the tests.

The other country that may be required to step in is Germany.

It can afford to recapitalise banks, but previous attempts to solve the problem have been scupper by regional politics and Chancellor Angela Merkel's reluctance to admit that German banks engaged in foolish lending. The test results, due in mid-July, may mean she no longer has a choice.

As many as one in six of Europe's banks are set to fail an EU-wide financial health check, euro zone sources close to the stress-testing exercise told Reuters on June 28.

Between 10 and 15 of the 91 banks being scrutinised are expected to fail.

The casualties are expected to include lenders in Greece, Germany, Portugal and Spain. "How many do we expect to fail? I would say 10 to 15," one senior euro zone central banking source told Reuters.

The European Banking Authority wants the number of banks that do not pass the tests to be around that level to show the examinations are serious, said a second source, adding that the authority did not want to push for more, for fear it could spark panic and intensify the euro zone's debt crisis.

"In order to demonstrate that it is credible, the EBA would need to show that the number of bank failures is significant, without being substantial," said the source. "A number in the teens is about right."

A spokeswoman for the EBA told Reuters that testing was still under way and declined to comment on what she called speculation about the outcome.

Copyright Reuters, 2011