FACTBOX-Methodology used for EU bank stress test

July 23 (BestGrowthStock) – European Union regulators have checked
91 of the bloc’s top banks to see if they hold enough capital to
withstand shocks worse than the collapse of Lehman Brothers bank
in September 2008, which triggered a near meltdown of global
financial markets.

The Committee of European Banking Supervisors (CEBS), made
up of regulators from the 27 EU member countries, looked at the
banks under three scenarios that replicated another recession
that culminates in a once in every 20 years crisis.

Those banks unable to maintain a Tier 1 capital ratio of at
least 6 percent by the end of 2011 under the most adverse
scenario used in the test were deemed to have failed.

The following outlines basic parameters of the test — the
second carried out in two years by CEBS — and main criteria in
the three scenarios:

BASIC PARAMETERS

The 91 banks hold 65 percent of the EU’s total banking
assets and at least half of banking assets in each of the 27 EU
countries. The banks are tested on a consolidated basis so their
subsidiaries elsewhere are included.

The base is a bank’s situation at the end of 2009 and the
scenarios cover a moderate recession over 2010 and 2011. All
banks were asked to complete the same test templates that looked
at risks on trading and banking books, including exposures to
home, corporate and interbank loans, interest rate volatility
and credit risks.

The test did not look at liquidity levels because of a
separate study being done by CEBS and the Basel Committee in
relation to new global liquidity rules.

Banks were asked to calculate losses on loan books and
securities under several scenarios. These were offset against
expected earnings in 2010 and 2011. The result was deducted from
Tier 1 capital. Meanwhile, risk-weighted assets rose to reflect
increased risks.

The ECB gave banks guidelines for the probability that
certain classes of loans would default, and the likely loss they
would suffer. Big banks were allowed to use their own models to
estimate losses, though under supervision of local regulators.

Banks failed the test if they were unable to maintain a Tier
1 capital ratio of 6 percent under each scenario. Under existing
regulatory requirements, banks must hold at least 4 percent in
Tier 1 capital but many of the bigger banks hold far more.

The average Tier 1 capital ratio rose from 8.3 percent at
the end of 2008 to 9.9 percent at the end of 2009.

The stress tests were done after the recapitalisations of
banks in Europe while the U.S. test done last year was conducted
prior to recapitalisation.

BENCHMARK SCENARIO

This is not a stress test but a basis for comparing the two
following stress test scenarios. It is based on existing
forecasts for EU economic growth issued by the European
Commission until the end of 2011.

The benchmark also assumes that stock markets fall 10
percent in 2010 and 2011, a cumulative drop of 19 percent.

ADVERSE SCENARIO

This imagines a double dip recession hitting Europe.

It assumes a cumulative average drop of 3 percent in
economic growth over 2010 and 2011, representing a bigger drop
in countries like Germany whose economy is very open to
fluctuations in trade.

Equity holdings in the available-for-sale portfolios were
stressed to assume stock markets plunge 20 percent in both
years, a cumulative rout of 36 percent that puts shares deep
into bear market territory.

The test assumed that credit ratings on holdings of
securitised products were downgraded by four notches across the
board.

Regulators also assumed that short-term interbank borrowing
rates rose by 125 basis points — similar to the aftermath of
Lehman’s collapse — for the entire two years. Long term rates
were assumed to have risen by 75 basis points.

The stress adjusted the probability of default (PD) and loss
given default (LGD) for loan portfolios under various scenarios.

CEBS said the test on the banking book stress both the
numerator and denominator for capital ratios — reducing the
capital held, and increasing the risk weighted assets.

CEBS and the European Central Bank believe its scenario has
a probability of happening once in every 20 years, which they
say is a more severe test than U.S. regulators carried out on
their banks last year, which was based on a once in every seven
years probability.

ADVERSE SCENARIO WITH SOVEREIGN DEBT SHOCK ADD-ON

In May, European leaders added a third scenario after market
concerns over bank exposures to the falling value of the
sovereign debt of peripheral euro zone countries like Greece,
Spain and Portugal.

This scenario includes an add-on whereby severe turmoil in
government bonds are included.

Under this scenario, long term interest rates rise by a
further 30 basis points in the euro area.

Based on the value of the bonds at the end of 2009, the
“haircut” or discount on five-year Greek bonds at the end of
2011 would be 23.1 percent, with the equivalent for Portuguese,
Spanish and German bonds set at 14 percent, 12.3 percent and 4.7
percent, respectively. The same haircuts were applied to all
government bonds, regardless of maturity.

The scenario does not assume that any default on a
government’s bonds as this was felt to be a “highly implausible”
event. As a result, the “haircuts” only apply to bonds held in
the trading book, although the sovereign stresses do feed into
credit losses in the banking book.

Despite this, each bank is expected to spell out its
holdings of government debt for all EU countries. This
disclosure separates the trading and banking book holdings, and
reports both gross and net positions, taking account of hedging
contracts.
Stock Investing

(Reporting by Huw Jones and Steve Slater, editing by Mike
Peacock)

FACTBOX-Methodology used for EU bank stress test