FRANKFURT (MNI) – Adverse scenarios tested in the European Union’s
stress tests include a mild recession over the next two years, stock
markets plunging by a fifth as well as interest rate shocks, European
Banking Supervisors (CEBS) and the European Central Bank confirmed
Friday.

The adverse macroeconomic scenario sees a decline of 0.3% of GDP
over 2010 and 2011 combined, which assumes a 3 percentage point
deviation of GDP for the EU compared to the European Commission’s
forecasts. The Commission had forecast EU GDP growth of +1.0% in 2010
and +1.7% in 2011.

While the ECB said a new downturn is “highly unlikely,” observers
have called for tests to include a more severe recession scenario than
the one that was tested for.

In addition to a mild recession, the tests also assume a 20%
decline in stock markets and a downgrade by four notches of credit
ratings on holdings of securitised products, CEBS said.

Regulators also tested a “common upward shift in the yield curve
for the EU as a whole, reaching 125 basis points for the three-month
market interest rates and 75 basis points for the ten-year market
interest rates at the end of 2011,” the ECB said.

The test scenarios also included “a country-specific upward shock
to long-term government bond yields that resulted in an overall average
increase of 70 basis points at the end of 2011,” the central bank added.

These rate shocks would result in yields of 3.5% and 4.7% for
five-year and a ten-year German government securities, respectively, by
the end of 2011. For Greek paper, the yields in this scenario would rise
to 13.9% on 5-year securities and 14.7% on 10-year bonds.

Based on these rates, the tests then applied additional haircuts to
sovereign bonds held on bank trading books.

A 4.7%-haircut would be applied to German five-year bonds in the
worst case scenario in 2011, CEBS said. For French five-year paper, the
haircut would equal 6.0%. Greek 5-year debt would get a haircut of
23.1%, Portuguese debt 14.1% and Spain 12.0%.

While figures tested for are significantly above present market
rates, critics will note that applying haircuts to trading books only
and not to banking books excludes all possibility of sovereign debt
default or restructuring. Yet many observers think that this risk
remains very real.

Rising sovereign yields were also translated into “large increases
in the probabilities of default of corporate and household debt to be
applied to the banking book,” the ECB said.

“For example, in the adverse scenario, the probability of default
of corporate debt for the euro area is taken to be 61.3% higher in 2011
than the actual default rate in 2009,” the central bank said.

The CEBS tests, which covered 91 banks constituting 65% of the EU’s
total banking assets, found that only seven European banks failed the
criteria of meeting a minimum 6% tier 1 capital ratio in adverse
scenarios. Fewer banks failed than had been expected, although tests had
already been viewed as weak. In total, they found an aggregate EU-wide
recapitalization need of just E3.5 billion.

The comparatively small number of both failed banks and total
required capital might also bolster the critics’ case for too lax
testing. In the US, stress tests had uncovered a need for roughly $75
billion of fresh capital.

However, the ECB notes that EU tests have been undertaken in some
cases after large-scale programs injected public capital into several
national banking systems and following a substantial increase in the
capital ratios achieved by EU banks since last year as a result of
retained earnings and new issuances.”

The euro had dropped sharply amid credibility concerns over the
stress tests, but it has since recovered most of its losses.

Markets are likely to take some time to digest the full details of
all individual bank results.

–Frankfurt newsroom +49 69 72 01 42; e-mail: jtreeck@marketnews.com

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