Weak scenario taints EU bank test results

By Boris Groendahl

VIENNA (BestGrowthStock) – The problem of Europe’s banking sector consists of seven small regional banks who need to raise 3.5 billion euros ($4.5 billion) between them to get into shape. Otherwise, everything is fine.

That was the message of European supervisors when they released the results of a health check of European banks that was deemed to restore confidence in sector plagued by persistent market mistrust into the quality of its assets and capital.

The results fell short of investor expectations of how many banks would fail and how much capital they would need to raise, fuelling doubts about the exercise which was already dismissed as a political show of European back-slapping.

“With a 92 percent pass rate, it is factually a success,” said Franklin Pichard, director of Barclays Bourse in Paris.

“But it’s true that it leaves the after-taste of work that has gone unfinished, because maybe it seems that success was the only possible outcome.”

The tests have served analysts with a huge data mine to dig into, and the level of detail released by the banks — including on sovereign bond holdings — could yet prove to be the key result that injects confidence.

If investors use this detail to run their own, stricter stress tests, and if their results are not much worse than the official ones, the tests could still turn out to do the trick.

The euro on Friday first fell as doubts rose about the tests’ credibility, but it later went back to the previous levels. The reaction of bank shares and the interbank market will be the key measures of success on Monday.

THREE THEMES

In the run-up to the test three themes have emerged as the ones investors are focusing on most: Its severity, the resolve of the measures to recapitalize problem banks, and the transparency it provides on individual lenders.

Here’s how the test met expectations on those measures:

* SEVERITY: FAIL. The ECB says its double-dip scenario used in the exercise has only a once-in-20-years probability, but the 3-percent drop of gross domestic product it factored in over two years did not impress market analysts.

Even less daring was the hit the scenario applied to government bonds, which turned out to be less dramatic that the real prices seen at the trough of the market in early May, just before the EU resolved to bail out Greece.

Also disappointing was that the sovereign stress was only applied to banks’ trading books, not to the banking books where an estimated 90 percent of them sit — but for which the test would have had to assume a sovereign default in Europe.

And finally, the required threshold of 6 percent tier 1 capital is not very demanding — investors would have like to see a test referring to the more stringent core tier 1 level.

However, a few national supervisors used additional stress: Spain assumed a hefty further slide in house prices, Austria made worse assumptions for an eastern Europe downturn and Greece tightened up some rules as late as Thursday.

* RECAPITALISATION: FAIL. The test organizers said the capital shortfall detected in the exercise amounted to 3.5 billion euros, at five Spanish cajas, Greece’s ATEbank and nationalized German bank Hypo Real Estate.

The U.S. stress test last year — the unofficial blueprint for Europe’s exercise — had half of the banks tested fail, and led to $75 billion of capital raisings, although the financial and economic backdrop looked far worse then.

A Goldman Sachs poll of 376 investors just before the results were released had shown the expectation that there would be a shortfall of 37.6 billion euros.

This is of course a direct result of the lenient assumptions of the test and the low threshold to pass. However, it also reflects that Europe’s banks were being tested after a series of recapitulations that already happened this year and last.

Credit Suisse analysts have calculated that European banks have raised 220 billion euros one way or the other in the last 18 months, and the results reflect this.

* TRANSPARENCY: PASS. The decision to publish the results bank-by-bank was a break with European supervisory tradition and let loose a steamroller that ultimately flattened all — mainly German and French — resistance against transparency.

The most unexpected show of openness is the release of detailed data on banks’ government bond holdings by most European banks, including all German landesbanks, including how they are split between the trading and banking book.

Just as possible subprime losses were the main uncertainty that was cleared by the U.S. stress test, sovereign bond holdings were the big unknown for European banks.

“The market, if you want, can go back and rework it,” said Philip Lawlor, investment strategist at Smith & Williamson. “The key thing is they are going to deliver on the transparency.”

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(Reporting by Boris Groendahl, editing by Mike Peacock)

Weak scenario taints EU bank test results