Up Front

The EU Bank Stress Tests Appear to Have Worked

Douglas J. Elliott

At first glance anyway, it looks like the EU bank stress tests basically worked, although there will certainly be criticism and disagreement about some of the assumptions used. Regulators across the European Union today released the results of the coordinated stress tests of the 91 leading banks in the union. The intent was to instill greater confidence among financial market participants that the major banks were sound and could withstand a possible further downturn in the economy and markets. The tests were modeled in many ways after the highly successful bank stress tests that the US ran in the spring of last year.

The tests were never destined to have as positive an impact as the US ones did, partly because restoring confidence is much more valuable in the middle of a panic such as we faced last year. Although the EU tests are designed to deal with doubts about the European banks, sentiment prior to the stress tests was far from being as negative as in last year’s panic. Nonetheless, the results appear fairly positive and should relieve some concerns. As I indicated in my analysis last week, I was looking for four factors to determine if the tests worked as intended:

The large majority of banks needed to pass, but some needed to fail. The tests would not have helped restore confidence if they showed serious weakness across the sector. However, they would not be credible if a few banks did not flunk, since the markets are well aware that some of the banks are quite weak. In the end, 84 out of the 91 banks were shown to have sufficient capital according to the test parameters, leaving 7 that flunked. Even some of the ones that flunked would still have enough capital to meet standard regulatory minimums, just not enough to meet the higher 6% Tier 1 ratio used in this test.

The assumptions in the test needed to be sufficiently stringent. This will probably be the area of biggest disagreement among analysts. On first glance, the assumptions appear to me to represent a fairly adverse scenario, as they are intended to do. However, there is a great deal of information to wade through and there will doubtless be arguments that certain assumptions were not tough enough. That said, it is important to remember that the same reaction occurred after the highly successful US stress tests. There does not need to be an absence of argument for these tests to have been helpful.

There must be sufficient transparency. The EU regulators appear to have taken the transparency requirement quite seriously. Although they did not provide every piece of information desired, there is enough being made available for a serious analyst to draw their own broad conclusions, which is the key test for transparency.

Governments need to be prepared to step in with support for those banks that flunk the test. Given the small number of banks that failed the test, it will not be hard for the authorities to deal with their capital and/or restructuring needs.

The real measurement of the effectiveness of the tests will be the financial market’s reactions. So far, most of the quite substantial gains in the price of European bank stocks that were spurred by the run-up to the announcement of the test results appear to be holding. It may, however, take analysis over the weekend for the markets to reach firmer conclusions.