The European Union's powerful new banking watchdog is preparing an extensive test of European lenders' ability to withstand future financial crises, documents from the watchdog showed on Tuesday.
But as banks ready themselves to run a gauntlet of theoretical economic setbacks in this year's "stress tests," analysts say the key questions now are how many banks will fail and whether failure will prompt them to quickly raise capital. The European Banking Authority (EBA), which is conducting the tests on 88 EU lenders holding 65 percent of the bloc's total assets over the coming months, has promised a tough exam for the region's lenders, after last year's tests were seen by financial markets as being too lax.
Criteria for banks' passing or failing the test are due to be set next month, but European Central Bank policy maker and German Bundesbank President Axel Weber warned not to expect dramatic changes.
"The stress scenarios have been made tougher," Weber told a news conference at Germany's central bank. Analysts were sceptical, however, saying they wanted to see action if banks' capital buffers prove to be inadequate. Last year 91 banks were tested and only seven failed, none of them from Ireland, whose banking sector the EU and International Monetary Fund had to bail out within months of the exercise, denting the stress test's credibility.
The EBA's tests will be run against a baseline and an adverse macroeconomic scenario that differed little from the solvency tests run last year. "It is composed of three elements: a set of EU shocks - mostly tied to the persistence of the ongoing sovereign debt crisis, a global negative demand shock originating in the US and a US dollar depreciation vis-a-vis all currencies," the EBA wrote in documents sent to banks to prepare for the test, a copy of which was obtained by Reuters. EBA's Chairman Andrea Enria will hold a teleconference with the participating banks on Friday, giving them additional information on the test methodology, the documents showed.
The EBA, launched in January with powers to impose binding standards on member states, is being watched to see how credible this year's test will be in restoring confidence in a sector that still depends on government support in some cases. The adverse scenario, designed by the European Central Bank, includes a 0.5 percent economic contraction in the euro area in 2011 and a 15 percent drop in European shares, the documents showed. For the first time, the scenario will also take account of a rise of 75 basis points in long-term yields for euro-zone government bonds and a sharp decline in the real estate market.
Increased tensions in wholesale funding markets, leading to a 125-basis-point increase in short-term interbank financing costs, will be simulated as well. The test will also include a scenario that foresees euro-zone GDP contracting by another 0.2 percent in 2012. The EBA will also test a global demand shock emanating from the United States and the effect of a 4 percent US dollar depreciation.
Banks will have to apply a valuation haircut to their sovereign debt exposure under the adverse scenario, with a haircut of 3.5 percent on German 10-year bonds and 7.6 percent on UK gilts of the same maturity, the EBA documents showed. As expected, the test will not include assets held in lenders' bank books, allowing periphery sovereign bonds classified as held until maturity to escape the same writedowns impacting their trading book under the test's scenario.
Banking observers have said they expected regulators to avoid commenting on liquidity altogether following the tests as even a whiff of concern could cause interbank lending to dry up. On Monday, Moody's highlighted eurozone risks when it downgraded Greece by three notches to "B1", on par with frontier sovereigns such as Vietnam, Bolivia and Albania. It said the likelihood of a Greek default or voluntary distressed debt exchange had risen.