Q+A: Will EU end row and toughen up bank stress tests?

By John O’Donnell and Edward Taylor

BRUSSELS (BestGrowthStock) – As European leaders approved a safety net for weaker countries, a row simmered over how to test lenders after previous checks came under fire for giving Irish banks a clean bill of health shortly before their near collapse.

WHEN AND HOW WERE THE LAST TESTS CONDUCTED?

In July, 91 EU banks were tested on how they would cope if lending such as home or commercial property loans turned sour.

But supervisors did not consider the risk of a bank being forced out of business if it struggled to get credit itself or if savers withdrew deposits, both factors that accelerated the demise of some of Ireland’s leading banks.

The July checks, embarked upon after similar U.S. tests were credited with reassuring investors, were meant to do the same in Europe by uncovering hidden problems and forcing weaker lenders to recapitalize.

Initially, news that only seven of 91 failed the test — none of them Irish — received a warm welcome. But some branded the exercise irrelevant in the months afterwards as Ireland was forced to accept an 85-billion euro bailout mainly to stop its banks from toppling.

With investor confidence in the euro zone shaken by indecision over how best to help countries that find it hard to borrow, Europe’s leaders are looking for ways to perk up pessimistic markets.

Stress testing the banks at the heart of the financial crisis may help. But they do not agree on how it should be done, and crucially whether they should include a so-called liquidity test to gauge their resilience if credit dries up.

WILL THE NEXT ROUND OF HEALTH CHECKS BE STRICTER?

Some of Europe’s leading politicians are very critical of the stress tests.

The European Union’s top economic official Olli Rehn recently called for tougher probing of banks in a fresh round of stress-testing planned for February, saying they must include a check on liquidity.

Jean-Claude Juncker, who chairs meetings of euro zone finance ministers, sent a similar signal on Friday after the break-up of the meeting of heads of state in Brussels when he said previous tests had not covered “all dimensions.”

But it is unclear whether such pressure from the European Union’s executive arm will succeed in overcoming reservations about harsher checks from Germany and others, who are nervous that over-rigorous testing may produce uncomfortable results.

WHY HAS GERMANY BEEN RELUCTANT TO BACK PUBLIC STRESS TESTS?

Any bank that fails a stress test would likely have to top up their capital cushion to persuade investors and lenders that they can survive should the crisis worsen or bad loans be written off.

Germany’s regional lenders, or landesbanks, are among the worst hit by the crisis and some of the country’s commercial banks — Hypo Real Estate and Commerzbank — count among its biggest European casualties.

Little, however, is known about the full extent of the problems at the country’s landesbanks, which were reluctant to publish the findings in the last round of tests. Some believe this has masked the vulnerability of German banks.

So far Germany has spent little propping up individual banks when compared to what other European countries spent. Instead it relies on the strength of its community savings banks — who most assume are cash rich despite the losses of the landesbanks that they own jointly with local governments — to keep the system afloat with liquidity.

Moody’s, the credit rating agency, warned in April that the reliance of German landesbanks on a system of mutual support for stability, rather than being individually strong “makes German banks more exposed to shocks and contagion risk.”

The agency’s analysts warned that the mutual support mechanisms were not up to coping with the financial crisis, writing: “Several of the larger public sector banks … remain too weak to fend for themselves in times of stress, let alone support others.”

So far, bust investment bank Hypo Real Estate is the only German lender to have been declared dangerously weak by stress tests. More rigorous stress tests could land the state with a far higher bill to support its landesbanks and rock confidence in Germany.

WHO DECIDES HOW STRICT THE CHECKS WILL BE?

The checks will be carried out by a new European banking authority in what will be the first trial of the fledgling agency, set up by Brussels to better police banking.

The London-based agency will take many of its staff from the ranks of the European Commission, which is already tasked with helping set the criteria for the stress tests. The European Central Bank also has a say.

But ultimately, it is the supervisors from countries such as Germany, who all have a say in the decisions of the European Banking Authority, which will make the final call.

Authorities like Germany’s Bafin, which earlier this year adopted a softer line with its banks, telling them participation in stress tests was voluntary, might again get their way.

(Editing by Will Waterman)

Q+A: Will EU end row and toughen up bank stress tests?