After the European Bank Stress Tests

Alicia Damley submits:

Underwhelming might be the best way to describe the results of the European bank stress tests and the market's reaction to them. Paying heed to market demands, the Committee of European Banking Supervisors ((CEBS)) released informative details on the stress test assumptions, which reveal that the adverse scenarios were not particularly unpleasant. A key assumption underlying the value of the analysis is that, given the number of variables stressed, the interaction of the variables was consistent with economic reality.

Overall, the adverse assumptions suggest that many conditions in Q1/2010 were already near the worst case scenario for most of the EU economies. This includes GDP growth, unemployment, sovereign credit risk, real estate price declines, and default and loss probabilities. Particularly problematic given market concerns about the amount of sovereign debt on European bank balance sheets was the scenario testing focused only on the bonds held for trading vs held to maturity. Simply put, Tier 1 ratio calculations increase both the risk weights attached to and the capital required to be held for government bonds which drop through AA-. The net effect is a rapid reduction the Tier 1 ratio unless new capital is raised since both the numerator and denominator move in opposite (adverse) directions. The modest decline in the Tier 1 ratio (110 bps), low estimated Tier 1 capital shortfall of €3.5 bn and corresponding low (7 out of 91) number of banks which failed are substantially attributable to this.

These tests have been determined, assessed and signed-off by national regulators and CEBS. So, a rational interpretation is that despite difficulties in reaching consensus to date, EU governments, particularly Germany and France in conjunction with the ECB, are fully back-stopping EU bank balance sheets regardless of country boundaries. With the SIV set-up complete under the May 2010 announced EFSM*, a vehicle already exists to accept funds.

Understandably, the markets have reacted positively to the bank stress test results. Numerous reassurances have been provided in the CEBS documents and conference call. However, a search of regulatory fickleness need not look far - Fortis' experience following the planned acquisition of parts of the ABN Amro business is a recent, painful reminder. Tread carefully - the EU bank stress tests are inconclusive on the investment opportunity in EU banks.

* European Financial Stabilization Mechanism announced May 2010 in response to the PIIGS spillover from the Greek sovereign debt crisis

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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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