Fears of eurozone deflation, emerging markets turmoil and a determination not to repeat past mistakes mean European regulators are likely to come up with the toughest set of tests for the region’s banks that they have ever faced.
The European Banking Authority (EBA) will today reveal the crisis scenarios that banks will have to prove they can withstand without resorting to the kind of taxpayer bailouts that all but bankrupted some countries in the 2008-2012 crisis.
Banks that fall short of capital under the imagined scenarios will have to produce a plan to boost their reserves by raising fresh funds from investors, selling assets or hanging on to profits instead of paying dividends.
Banks have already raised billions in capital and made other reforms ahead of the tests, which regulators hope will finally banish any investor doubts about the industry and allow it to refocus on lending to boost growth.
The European economy has rallied since the last round of bank stress tests three years ago and sharply lower borrowing rates for countries such as Greece – which can now borrow five-year money at an interest rate below 5 per cent against the 20 per cent it was paying when the 2011 tests were done – support the idea that the worst of the eurozone crisis has passed.
But with widespread criticism heaped on 2010 and 2011 stress tests for being too soft, and new risks on the horizon, regulators are likely to set tougher conditions all the same.
The scenarios will include testing banks against economic shocks outside Europe, a plunge in commercial property markets and also volatility in central and eastern currencies, according to a draft EBA statement quoted by Bloomberg.
“The key is that the scenario is at least as deep and dark as the great recession, the financial crisis of 2008/2009,” said Mark Zandi, Philadelphia-based chief economist at Moody’s Analytics. “You can easily conceive a scenario as severe as what we went through.”
Analysts view economic growth as the most significant factor in the stress tests, with losses on banks’ mortgages and business loans primarily driven by GDP projections, as well as assumptions around unemployment.
Figures leaked ahead of yesterday’s announcement show regulators are taking a tougher line on economic growth than in 2011, when 18 of the EU’s 27 countries at that time posted weaker growth than the ‘adverse’ case they were tested against for 2012.
The most dramatic miss was Greece, where an adverse scenario of a 1.2 per cent contraction in real gross domestic product proved far more optimistic than the 7 per cent contraction that actually occurred.
In Spain, there were initial reports that the latest tests would assess banks against a fall in economic output of as much as 6 per cent over the next three years, which would be much worse than during the recent recession, though several banking sources said the figure would now likely be lower.
One source with knowledge of the scenarios said there was a case for applying tougher scenarios for countries that had not yet had major crises, since those nations had further to fall.
The last version of the US stress tests set the adverse scenario for domestic GDP at as much as 4.7 percentage points worse than the expected scenario for one quarter, though the average gap was closer to 2 percentage points. The EU tests have a gap of between 1.5 and 2.2 percentage points between the base and the adverse cases.