8 banks fail Europe’s stress test

July 15, 2011, 8:06 PM UTC

European regulators said 8 banks will need 2.5 billion euros ($3.5 billion) to survive a serious downturn, and that 16 other lenders passed but should raise more money.

Of the failing banks — those whose so-called core capital fell below 5% — five are from Spain, two from Greece* and one from Austria, according to results released by euro area banking watchdogs. Of those that passed but could stand to bulk up, with core capital of 5%-6%, nearly half — seven — are from Spain.

Friday’s announcement from the European Banking Authority concludes the latest round of stress tests for 90 big institutions from Germany to Spain to Ireland. Policymakers are hoping to dispel worries about the capacity of Europe’s banks, which historically carry less capital and rely more on money borrowed in the markets, to survive a recession that slashes economic output by 4% over two years.

But any relief wasn’t immedately visible. European bank stocks traded modestly lower in the United States, and the spreads on the debt of weaker countries such as Greece, Portugal, Ireland and Spain widened modestly, indicating sustained stress.

Not too stressed

A well capitalized banking system is crucial for a European economic recovery. A recent paper by the Organization for Economic Cooperation and Development estimated that banks provide three-quarters of credit extension in Europe – three times as much as in the United States, with its government-backed mortgages.

The biggest, publicly listed banks such as Deutsche Bank (DB) of Germany, Barclays (BCS) of the U.K. and Banco Santander (STD) of Spain have been widely seen as sufficiently strong to pass the test.

Leaders of the European Union said this week they will stand behind those banks that aren’t able to raise capital privately, in a replay of the exercise the United States ran in the spring of 2009. The EBA said a dozen more banks would have failed the test if they hadn’t raised capital early this year. 

Concern has centered on the regional banks in Germany and especially Spain, where the cajas are widely viewed as undercapitalized and chock full of questionable loans made for political rather than economic reasons. Among those passing were the Irish banks whose massive bailout over the past three years has left the Irish state addicted to support from the European Central Bank and International Monetary Fund.

The latest tests come after a round last year was hooted down in the market after only seven, mostly smaller institutions were found wanting. Moody’s said this month it viewed 26 banks as bearing a “heightened risk of needing extraordinary external support.”

So the finding that 24 institutions need more money is definitely tougher and therefore more credible. Even so, many have questioned the utility of the tests at a time when investors are demanding much more compensation for the risk of buying bonds issued with large deficits, heavy debt loads or shrinking economies.

Every country’s banking system is ultimately backed by its national government, and when there are questions about the viability of economies as large as Italy (the euro area’s third-biggest), the mere observation that the banks have plentiful capital is not apt to ease investor fears.

The design of the latest stress tests drew further eye-rolling because they fail to assess what would happen to banks if a sovereign bond issuer such as Greece defaults. Since that is the very scenario investors have spent the past 18 months fretting over, it seems like a bit of an oversight.

But the EBA says it will test instead what will happen if the value of sovereign bonds are reduced.

“The adverse scenario also includes a specific sovereign stress in the EU leading to further falls in the price of some EU bonds from the already stressed levels seen at end 2010,” an EBA stress test explainer notes.

Further adding to the confusion, Spain’s central bank — which under the national regulatory arrangements in Europe is responsible for making sure its banks are adequately capitalized — said its banks won’t actually need to raise any more money, because of general loss provisions and their issuance of bonds that convert to stock in a failure.

This despite the fact that the EBA says it has urged local regulators to urge banks with capital “above but close to 5%, and which have sizeable exposures to sovereigns under stress, to take specific steps to strengthen their capital position.” That seems to apply to numerous Spanish lenders, but the Bank of Spain doesn’t appear to agree.

*Correction: Initially I erroneously wrote Germany. My apologies for the error.