Europe Stress Tests May Underestimate Probable Losses

Bloomberg | Jul 8, 2010

Angel Merkel European stress tests on 91 of the region’s biggest banks drew criticism from analysts who said regulators are underestimating probable losses on Greek and Spanish government bonds. The tests are designed to assess how banks will be able to absorb losses on loans and government bonds, the Committee of European Banking Supervisors said yesterday. Regulators have told lenders the tests may assume a loss of about 17 percent on Greek government debt, 3 percent on Spanish bonds and none on German debt, said two people briefed on the talks who declined to be identified because the details are private. “This isn’t a stress test,” said Jaap Meijer, a London- based analyst at Evolution Securities Ltd. It’s “merely the current valuation of government bonds.” Credit markets are pricing in losses of about 60 percent on Greek bonds should the government default, more than three times the level said to be assumed by CEBS. Derivatives known as recovery swaps are trading at rates that imply investors would get back about 40 percent in a Greek default or restructuring. “I wonder how much these stress tests are reverse- engineered to inspire confidence in the market” and banks, said Bruce Packard, an analyst at Seymour Pierce Ltd. in London. “If they are too aggressive, everyone fails.”

Stocks Rally

The 54-member Bloomberg Europe Banks and Financial Services Index increased 1.5 percent today, bringing this week’s gain to 8.4 percent. Royal Bank of Scotland Group Plc rose 3.7 percent to 44.42 pence as of 8:44 a.m. in London trading. Paris-based BNP Paribas SA climbed 3 percent to 49.43 euros and Dexia SA, the largest lender to local government in France and Belgium, rose 3.5 percent to 3.17 euros. Lenders that account for 65 percent of the EU banking industry will be tested, including 14 German banks, 27 Spanish savings banks, 6 Greek banks, 5 Italian banks, 4 French banks and 4 British banks, CEBS said in a statement. EU regulators are relying on the stress tests to restore public confidence in banks amid concern that some lenders don’t have enough capital to 

withstand a default by a European country. A stress test of U.S. banks last May spurred a rally that lifted the Standard & Poor’s Financials Index 36 percent in the following seven months. “I think they are letting the banks off lightly,” said Stephen Pope, London-based chief global equity strategist at Cantor Fitzgerald. “This sounds like the softest option possible.” Regulators should be applying a 20 percent haircut on Greek bonds and 7 percent on Spanish debt, he said.

Angela Merkel

A CEBS spokeswoman in London declined to comment on the discussions. The EU will disclose the results of the tests, showing how individual banks would hold up to economic and market shocks, on July 23, German Chancellor Angela Merkel said yesterday. Policy makers haven’t decided how much detail to disclose. The tests assume a 3 percentage point deviation from the European Commission’s economic forecasts over two years and a deterioration of sovereign debt risk as compared to market prices in early May, CEBS said. The Commission estimates the EU’s economy will grow by 1 percent this year and 1.7 percent next year. The U.S. stress tests carried out last year found 10 lenders needed to raise $74.6 billion of capital. The “more adverse” scenario assumed the economy would shrink 3.3 percent in 2009, while unemployment would rise to 8.9 percent. They also assumed the U.S. economy would grow 0.5 percent the following year, while the jobless rate would surpass 10 percent. The tests didn’t include a measure of the impact of a drop in sovereign debt. CEBS is working with the European Central Bank on several cross-border lenders, which represent more than “60 percent of the EU banking sector in terms of total assets,” the agency said last month. CEBS’s role is to coordinate national banking authorities and make policy recommendations to the EU on regulation.


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