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July 24, 2010

European banks may face harsher tests from market
JUL 23, 2010 15:56 EDT
BANKING | EU | GOVERNMENT BONDS | STRESS TESTS
Europe’s bank tests were not stressful enough. Only seven of the 91 lenders participating in the exercise administered by the continent’s regulators will need extra capital to see them through a severe economic shock. The exams were undermined by failing to imagine a sovereign default. Forcing banks to disclose their government bond portfolios, however, gives investors the power to conduct their own more rigorous assessments.

The official tests fell short in two important ways. First, regulators used Tier 1 capital to assess balance sheet strength, clearing any bank that had a ratio of more than 6 percent after a two-year economic shock. But Tier 1 capital, which includes hybrid debt and other non-equity instruments, has been widely discredited. Investors no longer trust it, while regulators are trying to agree a tougher definition of capital.

The second, and bigger, failing was the way the tests handled sovereign debt. Despite concerns about the finances of Greece, Spain and other euro zone countries, banks were not forced to withstand a hypothetical default. The compromise regulators devised was to assume a sharp widening of government bond spreads.

This test, however, only affected portfolios that are marked to market. The vast majority of banks’ government bonds are held in so-called banking books, which only must recognize a loss in the event of a default. As a result, all but one of Greece’s banks passed the test, despite huge holdings of their own government’s debt.

At least what the tests lack in severity they make up for in disclosure. Banks were asked to spell out their holdings of EU government bonds, and to specify what proportion is held in banking books. It is up to individual lenders to release that information, but with the exception of a handful of German banks — including Deutsche Bank — most have already done so.

This information will allow investors to make up their own minds about the sovereign risks on the banks’ balance sheets. Those institutions deemed too risky will probably find it hard to access funding unless they raise more capital. And banks are bound to find the market’s stress tests tougher than the one they just completed.
Focus shifts to EU banks to scrape test pass

9:07am EDT
By Steve Slater and Edward Taylor
LONDON/FRANKFURT (Reuters) – So few banks failed Europe’s long-awaited stress tests on Friday that investors will likely focus instead on the dozen or so banks that just scraped through when markets reopen next week.
Seven banks failed the unprecedented test of Europe’s banking system — including five small regional Spanish lenders — and need to plug a much smaller-than-expected combined capital shortfall of 3.5 billion euros ($4.5 billion).
But the health check on 91 banks in 20 countries was criticized as being too soft. It was also overshadowed somewhat by a slew of data on European economies that suggested the banks may face less pressure and loan defaults than earlier thought.
That leaves investors to make up their own minds about particular banks, armed with the extra data the tests provided, including on sovereign bond holdings, to judge where further weak spots may be.
“With so few banks failing, investors will question whether the economic scenarios are sufficiently severe,” said Jon Peace, analyst at Nomura in London.
“It will be natural for investors to consider the margin by which banks passed,” he added, citing a good pass margin for Scandinavian and British banks, but Greek, Spanish and Italian banks faring less well.
Banks were tested on how they would withstand another recession in the next two years, including some losses on government bonds. They failed if their Tier 1 capital ratio dropped below 6 percent.
There were 17 banks whose ratio fell to between 6 percent and 7 percent.
They included Deutsche Postbank, Greece’s Piraeus Bank, Allied Irish Banks, Italy’s Monte dei Paschi di Siena and UBI Banca, Spain’s Bankinter and eight smaller Spanish banks.
WEAK LINKS
Even in the hours before the results w ere released National Bank of Greece, Slovenia’s NLB and Civica in Spain all announced plans to raise capital.
Piraeus has already hired three investment banks to underwrite a capital increase of more than 1 billion euros, a Greek newspaper said on Saturday, although much of that may go on the acquisition of state stakes in two other Greek banks.
Postbank, Germany’s largest retail bank by clients, identified its own capital shortfall months ago. The Bonn-based lender last year took drastic measures to improve capital, including scrapping its dividend, cutting staff and shrinking assets. It said it will continue with the overhaul.
Franz-Christoph Zeitler, Bundesbank’s vice president, said: “In the regulators’ view no other German bank (other than Hypo Real Estate) needs further capital as the level of 6 percent is clearly above the regulatory minimum, but the markets could see that differently.”
Italy’s smaller banks will also come under scrutiny.
“As we expected, bigger banks have higher capital ratios, while the market will probably say that banks such as Monte dei Paschi and Banco Popolare still lack adequate ratios,” said Centrosim analyst Luca Comi.
ACCESS TO FUNDING?
A main aim of the test was to open up funding markets for banks who have been shut out in recent months. Those still deemed too risky could still have problems unless they raise more capital.
“This isn’t necessarily the last word, and if funding costs do not improve for some banks then we would not be surprised to see additional stress tests by some national central banks in the future,” Nomura’s Peace said.
Europe’s so-called “stress tests” were never expected to show massive capital shortfalls, as its banks have also already raised about 300 billion euros since the start of the crisis. That includes about 170 billion euros of government support to 34 banks.
Just as investors take a view when markets reopen on Monday, Central bank governors and heads of supervision will meet in Switzerland to review proposed capital reforms, and the resilience shown by Europe’s banks could make it harder for them to argue they cannot implement tough new rules.
“The banks are ready to start implementing the new rules which are necessary to reinforce the capital provision and liquidity management of the banks,” Vitor Constancio, ECB Vice President, told Reuters Insider after Friday’s results.
(Additional reporting by Philipp Halstrick, Huw Jones, Antonella Ciancio and Angeliki Koutantou; editing by Patrick Graham)

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