–Tests Will Apply A More Restrictive Definition Of Core Tier 1 Capital
–Test To Include Sovereign Debt Shocks By Country, But No Default
PARIS (MNI) – The new European bank stress tests currently
underway apply economic and financial scenarios that are more severe
and less likely to materialize than the ones used in last year’s widely
criticized tests, according to documents released Friday by the newly
created European Banking Authority.
The London-based EBA, which is coordinating the tests, said they
will include rigorous review and quality checks at multiple levels to
ensure that the results are reliable and consistent across EU countries
for comparable institutions.
The tests will cover banks collectively holding more than 65% of
European banking assets and at least 50% of assets in the national
banking sectors of each EU member state.
That is comparable to last year’s tests, administered by the
Committee of European Banking Supervisors (CEBS), which was replaced on
January 1 by the EBA.
The CEBS-coordinated tests were widely discredited for lack of
rigor and for applying shock scenarios that were too optimistic. All
Irish banks passed the tests, and shortly afterwards the Irish banking
system suffered a systemic meltdown that has brought the country to its
knees.
The EBA said that supervisors, in designing the new tests, took
into account areas where improvements from the 2010 tests were deemed
necessary on the basis of a “lessons-learnt” analysis.
“The adverse scenario, designed by the ECB, is more severe than the
2010 CEBS exercise in terms of deviation from the baseline forecast and
probability that it materializes,” EBA said. It is less likely to
materialize, the agency said, because the economy is much stronger this
year and the baseline forecasts to which it is compared are rosier.
The worst-case scenarios in the tests, which cover 2011 and 2012,
include shocks to GDP and employment that are considerably bigger than
in last year’s tests. They include a spike in interest rates and a
considerable drop in equities.
Contrary to some press reports, which had suggested that national
bank regulators would be allowed to apply their own bank capital
standards, the tests will include a unified and more restrictive
definition of core 1 tier capital than last year. “The EBA is currently
defining common criteria for core tier 1 capital that will be applied
consistently across the EU,” the agency said.
The tests also include a scenario of further sharp drops in the
values of EU sovereign bonds from the already hard-hit levels of 2010.
The application of these hypothetical sovereign haircuts will be
accompanied by “full disclosure of all relevant sovereign holdings,” the
EBA said.
But these haircuts, calculated by the ECB in line with the adverse
economic scenarios, will be applied only to banks’ trading books. They
will not apply to the banking books, which are meant to be held to
maturity. Thus, the tests — like last year’s — exclude the possibility
of a sovereign default or restructuring, despite the fact that markets
widely expect one in the case of Greece.
Under the adverse macroeconomic scenarios for which banks are to be
tested, Eurozone GDP is assumed to contract 0.5% in 2011, compared with
a baseline forecast of +1.5%. That’s a negative swing of two full
percentage points from the baseline, compared with a 0.9 point swing in
the first-year adverse scenario of the stress tests conducted in 2010.
For the second-year adverse scenario, however, there is virtually
no difference between this year’s tests and last year’s. The negative
deviation in GDP from the baseline in 2012 is again two percentage
points. In last year’s test, the deviation for 2011 — the comparable
year — was 2.1 points.
With regard to potential labor market shocks, this year’s tests are
considerably more severe than last year’s. The first-year deviation from
the baseline unemployment rate is +0.3 point (10.3% vs. 10.0%), and the
second-year deviation is 1.2 points (10.8% vs. 9.6%). That compares with
deviations of just 0.1 point and 0.6 point in last year’s tests.
The tests will also probe banks’ state of readiness for a series of
financial market shocks, which include a 15% drop in European equities,
an 11% decline of the U.S. dollar against other major floating
currencies, a spike of 125 basis points in short-term interest rates,
and average long-term sovereign bond yields that are 75 basis points
higher than baseline.
Liquidity risk is not specifically assessed as part of this year’s
stress tests, EBA said. But they do examine changes in the cost of
banks’ funding, particularly as a result of stress on sovereign debt.
One flaw likely to get some attention is that the tests do not
include a shock to commodities, except for a “transitory” 5% increase.
In the first phase of the tests, which began on March 4, banks will
perform their own calculations based on the criteria provided. They will
then deliver the results to their national regulators, who have until
April 29 to review, quality-check and challenge them, before delivering
them to the EBA.
The EBA, in conjunction with the ECB, the European Commission and
the European Systemic Risk Board, will conduct its own quality controls,
which it expects to complete at the end of May.
EBA said bank-by-bank results will be published in June, along with
backstop measures for specific banks found to be vulnerable.
–Paris newsroom, +331-42-71-55-40; bwolfson@marketnews.com
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