European officials are about to decide how much pain their banks should be able to take.
European Central Bank and European Union regulators will hold conference calls this week to agree on scenarios to test lenders’ resilience to falling economic output, slumping asset prices and rising interest rates, according to two people with knowledge of the talks. They declined to be identified because the discussions are private.
The challenge is to find a model of trouble that is dire enough to show how robust Europe’s financial system is, without unsettling investors by causing too many banks to fail -- and one that can gain acceptance in 28 countries. The stress tests represent the last part of ECB President Mario Draghi’s effort to stamp out lingering doubts about the health of the region’s lenders before his institution becomes the euro-area’s prime bank supervisor in November.
“It has to be a scenario that makes sense, that’s deep enough to stress the banks yet still have a manageable reaction,” said Anatoli Annenkov, senior European economist at Societe Generale in London.
The ECB has said that it will communicate the outcome of the scenario talks at the end of April, in time for stress testing to begin next month of 128 banks that it is scrutinizing before it starts supervision in November. An ECB spokeswoman declined to comment on this week’s discussions.
The ECB has said the test will cover a three-year time horizon, until the end of 2016, with a main scenario and a so- called adverse scenario.
Executive Board member Yves Mersch said last year that the base case would center around the European Commission’s spring economic forecasts. The EU executive’s winter predictions released in February showed growth of 1.2 percent in the euro area this year, with Germany’s economy expanding 1.8 percent and a range of expansions from 4.2 percent growth in Latvia to a contraction of 4.8 percent in Cyprus.
European officials may look to the U.S. Federal Reserve’s recent stress tests for guidance on the adverse scenario, said Christian Thun, a Frankfurt-based senior director at Moody’s Analytics. He described them as “good benchmarks to get an idea of the severity” of the EU exams.
Under the Fed’s adverse scenario of rising unemployment and interest rates, coupled with a 36 percent drop in equity prices, 30 banks lost $267 billion on loans, including credit cards, commercial real estate, and mortgages. Incorporating an even worse scenario, Zions Bancorporation failed the test, while the Fed expressed concern about capital planning at Citigroup Inc. and U.S. units of Royal Bank of Scotland Group Plc, HSBC Holdings Plc and Banco Santander SA.
For the EU exam to show credibility, “the shock has to be realistic to today’s problems, like a hard landing in China or a faster than expected U.S. tapering,” Societe Generale’s Annenkov said.
The EU stress tests, the first combined exams across the bloc since 2011, will require banks to maintain a capital pass mark of 5.5 percent of risk-weighted assets. They will study aspects of credit, market risk, securitization and cost of funding. Both trading and banking book assets will be tested.
Sovereign bonds will form part of the exercise, though the ECB is wary of simulating a return to bond yields that threatened to break up the euro area at the height of the debt crisis. The spread between Greek and German 10-year bonds rose to as much 35.3 percent on March 2, 2012, before falling to 4.8 percent on April 11.
For euro-area lenders, the stress test will mark the final stage of the ECB’s so-called comprehensive assessment of their balance sheets, and follows on from an asset-quality review. The data from the asset review, an unprecedented check of bank balance sheets, will form the inputs for the stress test.
“A lot is at stake,” said Thun. Failure will “not only undermine the credibility of the European Central Bank but also severely hinder the recovery of the European economy in the years to come.”
Regulators want to avoid comparisons with previous tests. In 2010, within months of passing exams by the now-defunct Committee of European Banking Supervisors, Ireland’s two biggest banks needed a bailout. A year later, Dexia SA, the French- Belgian lender, received a clean bill of health in a test by the European Banking Authority, which took over from CEBS, and then failed after a bank run three months later.
“Stress tests in the past were not very convincing,” Klaus Regling, head of the euro area’s rescue fund, told Bloomberg Television last week. The exams “that are now under preparation by the EBA after the asset quality review of the European Central Bank will be much stricter.”
The flip side to being too lax is that in the struggle to earn back lost credibility, the EU could go too far.
“A very, very tough stress test that would lead banks to overcapitalize wouldn’t be helpful,” said Christian Schulz, senior European economist at Berenberg Bank in London, which predicted a 300 billion-euro ($417 billion) capital shortfall for EU lenders last year. “Do you want banks to prepare for an economy in eternal decline?”