Stress tests: getting it right this time around?

What happened last time

Last summer, of the 91 banks in Europe that underwent the stress tests, seven failed: Hypo Real Estate, in Germany, and Agricultural Bank of Greece, together with the five Spanish banks: Diada, Espiga, Banca Civica, Unnim, and Cajasur. However, a further 17 would not have met the challenge if the tier-one ratio had been set at 7% instead of 6%.

Banks were tested on their ability to cope with two scenarios: a benchmark scenario and an adverse scenario. The benchmark scenario assumed a mild recovery from the downturn. The adverse scenario, heavily criticised for its timidity, was based on two main elements: first, a fall by three percentage-points in the EU's gross domestic product compared with forecast; second, an assessment of sovereign risk, testing how a bank would cope with a fall in the market value of government five-year bonds by an EU average of 8.5%.

The Committee of European Banking Supervisors said that this would amount to a deterioration of market conditions comparable to the peak of Greece's debt crisis in May 2010.

Reserves and capital

Banks are required to maintain tier-one capital, comprising equity capital and disclosed reserves, at a certain level as a safeguard against failure. Last year's tests examined whether banks could sustain tier-one capital of at least 6% in the face of turmoil. Critics say that this test was not strict enough, because it did not measure “core” tier-one capital – the part of the tier-one capital that does not include subordinated debt, and is seen as a better measure of financial strength. By contrast, US stress tests did measure core tier-one capital.

Gradual phasing out of state aid to banks

The banking sector has received hundreds of billions of euros in state aid since emergency measures were introduced to help cope with the crisis in October 2009.

State aid to the banking sector is inextricably linked to the stress-test exercise, because the tests are supposed to identify which banks are in trouble before they need extra financing.

In 2009, the latest year for which the European Commission has detailed figures, EU member states spent €1.1bn propping up banks.

One of the reasons that national regulators have come under suspicion of treating banks too leniently is that governments would have to contribute more to keep their banks afloat if the reality of the situation were known.

The EU's emergency state-aid measures will, however, come to an end soon. On 2 February, Joaquín Almunia, the European commissioner for competition, signalled that the measures would be gradually phased out, with the pre-recession status quo returning by 1 January 2012.

Undercapitalised
But many parts of the European banking system are still significantly undercapitalised. Some analysts say that spending large amounts of taxpayers' money is the only way that Europe's economy will ever recover. They fear that without a complete restructuring of the sector – together with continued state aid in sizeable amounts – financial markets will not be calmed.

In some countries the return to the status quo has meant the consolidation of the banking sector. The Commission, though, is eager that this practice does not result in the merger of two unviable businesses which have just as many problems as before. The Commission says that government aid should be given only when it allows the banks to restructure and then operate according to a viable business model. As with the stress tests, that could take more political will than has been shown thus far.