LONDON: Investors hoping for clarity from this year's European stress tests can expect at best to be given enough data to run their own assessment.
The problem is that the new regulator running the exercise is unable to challenge EU policy that simply will not accept any of its member countries could default, even theoretically.
"They have to go for the second-best solution, which is giving transparency of banks' sovereign exposures so that investors can calculate the implications of this particular stress factor themselves," said Nicolas Veron, senior fellow at Bruegel, a Brussels-based think-tank.
The aim of the tests is to restore confidence in the region's banking sector after last year's health check was widely criticised for lack of transparency and credibility.
Only seven banks failed last year's tests and needed to raise just 3.5 billion euros, far less than expected. All of Ireland's banks passed, yet months later Dublin needed an 85 billion euro bailout and all its lenders had to be rescued.
Though the 2011 exercise is being run by the new European Banking Authority (EBA), under pressure to prove its own credibility as a regulator, it will still be flawed by the same inability to force banks to show a loss on assets held in their long-term "banking book," where they park sovereign bonds.
Elemer Tertak, director of the European Union executive's banking and financial markets department, told Reuters last week that testing the worst-case scenario of a euro zone sovereign debt default remained a sensitive issue insofar as including such a scenario could send the wrong message to the markets.
"From Shakespeare we know that self-fulfilling prophecies are the worst kind of prophecies," he said.
Mediobanca Securities estimates banks would suffer losses of 130 billion euros on their sovereign debt holdings if a tougher economic shock than last year was applied to both the trading and banking books for a broad sample of lenders.
Spanish, Italian and French banks would be hit hardest.
However the shock banks will actually be tested against does not look that much more severe than last year, though there will be new elements such as a fall in property prices.
EBA chairman Andrea Enria discussed the test with the 88 banks being assessed and their national regulators on a conference call on Friday. The EBA will release details of the economic shock scenario on March 18 with full methodology set to follow in April, well ahead of results in June.
There is some sympathy for its position.
"Provided you get the disclosures for the market to run its own stress tests I don't think it's a fatal problem that the banking book isn't stress tested," said Mike Harrison, analyst at Barclays Capital.
FULL TRANSPARENCY?
To run your own test, however, you need to know that the capital being tested across countries is of roughly the same quality, not an easy task without full transparency.
Last year banks had to meet a Tier 1 capital requirement of 6 percent to pass. This refers to a broad measure of a bank's resilience to shocks, but lenders can pad it with lower quality assets which obscure exactly how much cash is available to tap.
Analysts would have preferred to use a stricter 'core' Tier 1 benchmark comprising shareholders' capital and retained earnings, possibly with a 5 percent pass rate. That is opposed by some countries as it would make the test harder to pass.
Germany, for example, wants to include the debt-equity hybrids known as "silent participations" commonly held by its banks, sources familiar with the matter have said. This form of capital has been criticised because it cannot absorb losses while the bank is still in business.
The solution could be to stick with Tier 1 capital, but include a detailed breakdown of what it contains.
Another proposed improvement is to highlight the banks that nearly miss the stress tests requirements, in order to pressure them to recapitalise.
The test also looks set to apply higher funding costs and greater losses from a fall in property prices. It should also ensure that economic stress scenarios are consistently applied under similar accounting rules.
Regulators are also sticking their necks out politically by insisting that governments have a plan in place to top up capital at banks that fail, unlike last year.
DIY TESTING
Regulators say greater transparency means investors and analysts can run their own tests or add elements if they don't think the EBA is being tough enough.
Some analysts have already had a dry run.
Mediobanca Securities said a harsh test would knock the average 2012 core Tier 1 ratio of a broad sample of banks to 7 percent from a base forecast of 11 percent, still in line with new capital standards coming into force from 2013.
Last year's results offer a starting point on who is most at risk this year. In addition to the seven failures, 17 more would have flunked if the pass mark had been 7 percent and a further 15 were under 8 percent. Those banks would have needed about 30 billion of capital to get to 8 percent.
Many of the "near fail" banks have since raised capital, or announced plans to, including Spain's Bankinter this week.
Italian banks including Monte dei Paschi and Banco Popolare look most in need of capital, plus more Spanish cajas, Portugal's BES and German landesbanken like NordLB, analysts reckon.
"We expect the test to be a real game changer in the industry, acting as a catalyst for bank recapitalisations," said Chris Wheeler, analyst at Mediobanca.
Although that could be negative in the short-term, it would mark a long awaited step to force management to move "from denial to contrition" on the need for more capital, he said.
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