* The Euro Crisis ~ Waiting for D-Day

Europe's Financial Giants Nervous on Eve of Stress Test Release

European banking centers, like Frankfurts, are jittery ahead of the publication of stress test results on Friday.

By Anne Seith ~ 07/22/2010

source: http://www.spiegel.de/international/business/0,1518,707957,00.html#ref=nlint

On Friday, European banking authorities will release the results of the first major stress test of the Europe's banks. Doubts have been raised about the rigor of the tests and some fear it will just be a staged show of stability for the industry. SPIEGEL ONLINE analyzes what the stress tests will actually deliver.

Externally, the message is one of calm and tranquillity. With European stress tests set to be released at the end of European trading on Friday, banks and financial oversight authorities are at pains to demonstrate that they have everything under control.

Behind the façade, however, it is a different story. Financial institutions, national oversight authorities and the Committee for European Banking Supervisors (CEBS), which is carrying out the tests, are hectically finalizing their plans for Friday. Exactly when and how the results are to made public was to be the subject of a Thursday conference call among the European Union ministers concerned.

Even the timeline itself, which had seemed set in stone for weeks, was up for debate again this week. The plan to release the results on Friday evening was initially seen as a way to give banks the weekend to react to bad news if they needed to. Suddenly, though, there was talk of already going public on Friday morning. Some were concerned about giving markets in the United States a head start in interpreting the results -- as though nobody had thought of it before. A European Commission spokesperson had to clear the waters -- the original plan remains valid: The results will be released on Friday at 6 p.m.

The last-minute chaos belies the stability the stress tests are supposed to inject into European financial markets. As concerns over sovereign debt have grown in Europe, banks been having an increasingly difficult time raising money. With investors increasingly doubting their durability, Spanish banks, in particular, have complained of trouble. In response, Madrid took the initiative in lobbying for the publication of the stress tests as a way of injecting confidence into European financial markets.

Whether it will work, remains to be seen. Many experts have complained that the tests have not been rigorous enough and worry that the markets won't take them seriously. Some bank managers, meanwhile, worry that too much honesty might harm their institution's image.

But how do the stress tests really work? What is the point? And what effects might they have on European financial markets? SPIEGEL ONLINE takes a look at the most important questions.

Part 2: Who and What Will Be Tested?

A total of 91 banks are taking part in the tests. They cover two-thirds of the European market. In Germany, 15 banks are submitting themselves to the tests, accounting for 60 percent of the country's banking business. At 27, Spain is the country with the most banks taking part.

The financial institutions taking part have to fill out a form providing an entire catalogue of figures to the London-based financial regulator CEBS. They must also include a presentation of what losses they would face in the case of a second recession and a collapse of the stock markets in Europe in 2010 or 2011. Various stress scenarios have been created for this, though they vary from country to country. In some cases they even vary according to the bank that is being tested.

The decisive question, however, is the same for each of the institutions: How high would your equity-to-assets ratio be after the simulated crises at the end of the coming year? Neither banks nor regulators have ever before published these kinds of estimates. The benchmark that has been repeatedly cited in recent days under which the banks' equity ratio cannot fall is 6 percent. It is, however, not yet clear if that figure is binding. The final decision as to whether a bank has passed the stress test is made by CEBS.

THE STRESS TEST SCENARIOS
Overview

The stress tests will probe 91 important banks in the European Union to see how they might react to an economic crisis. Fifteen German banks are to be examined. The banks will be tested using three computer-simulated risk scenarios.

Stage One -- Normality

First, the tests will examine how the banks' capital reserves and other core indicators would develop should the euro-zone economy develop as the European Commission expects.

At the beginning of May, the Commission projected EU-wide growth to be 1 percent in 2010 and 1.5 percent in 2011. For the 16 euro zone countries, the Commission expects growth to hit 1 percent in 2010 and 1.7 percent in 2011.

Stage Two -- Crisis

This stage looks at how banks would cope should the European Union economy develop more poorly than expected over the next two years. Aberrations of up to three percentage points from Commission projections will be factored in.

Growth aberrations will vary by country in this scenario. According to financial industry sources, the stage two scenario factors in German GDP growth of 0.2 percent for this year and a shrinkage of 0.6 percent for 2011. By way of comparison, the German economy shrank by 5 percent in 2009.

This scenario also includes a flattening out of the (interest rate) yield curve, a situation which would cause significant problems on the bond markets. Many banks have large bond holdings, making them vulnerable to difficult bond market conditions.

Stage Three -- Crash

Stage three envisions and extension of stage two and involves a crash of European national bond markets. According to the European oversight body CEBS, which is carrying out the stress tests, this stage involves the simulation of a shock, not unlike that which took place at the height of the European debt crisis this spring.

During that crisis, risk premiums on bonds issued by problem countries climbed rapidly. Trading of national bonds -- with the exception of those issued by Germany -- almost came to a complete halt.

The stage three model reproduces that scenario. Banks are to be checked to see how they would handle a rapid increase in spreads (interest rate differences between bonds from troubled countries and the German benchmark bonds) and an increase in national bond returns of 30 basis points, which would result in a decrease in value of those bonds.

This test is likely to hurt banks which hold large quantities of bonds from highly indebted countries such as Greece, Portugal and Spain.

German Banks Being Tested

Part 3: Are Any German Banks at Risk of Failing?

Politicians and banks are falling over one another at the moment with reassuring statements. It seems as if only one really big bank in Germany could possibly fail the test: the Munich-based Hypo Real Estate (HRE). But that doesn't really come as a surprise given that the bank has already been nationalized -- and only has limited significance. "Everyone knows that HRE is being restructured," says analyst Konrad Becker of the Munich-based private bank Merck Finck. The institution may be tested on the basis of its current situation, but it has already started moving toxic assets into a so-called "bad bank."

Rumors that Germany's Postbank could have problems passing the test due to its low equity ratio of 7.3 percent have been vehemently denied by sources close to the bank.

Outside of Germany, a few Spanish savings banks are regarded as looking doubtful as is Slovenia's Nova Ljubljanska Banka, whose need for capital on the markets is no secret. Some have said the tests will not be taken seriously if nearly all banks pass. But some sources in the banking world have warned off the record of "a few nasty surprises." Analyst Becker, meanwhile, believes that "a few banks in the single figures" will fail.

Part 4: What Happens to Banks that Fail or Barely Pass the Test?

European officials have decided to publish the results after markets close on Friday, providing banks with a full weekend to obtain new capital if the stress tests spark an emergency. Memories of a similar test conducted in the US last year are still fresh in many minds here: 10 of the 19 institutions that were probed required billions in capital infusions from the government after results were published.

But Europe feels well-prepared for this financial D-Day. International Monetary Fund (IMF) chief Dominque Strauss-Kahn recently stated: "I get the feeling that what will come out will be rather reassuring, and that we'll see that all the big European banks are sufficiently solid to resist any earthquake." Nevertheless, the stress tests could create trouble for smaller banks.

The issue of the day, though, is more likely to be how the markets will react to those banks that just barely manage to scrape their way through the stress tests -- particularly if very few financial institutions fail. In Germany, for example, the state-owned NordLB could fall under the pivotal core Tier 1 capital ratio of 6 percent. Postbank and the Landesbank Hessen-Thüringen (Helaba) could also be very close to the limit. Will investors take into account unique factors facing individual banks? Or will they be immediately punished?

On the eve of stress test publication day, no one knows. It is a fact, however, that in many countries, government rescue funds could easily spring into action to provide fresh capital in an emergency. The German government's SoFFin bank rescue agency, for example, still has €50 billion of a total of €80 billion at its disposal. And the finance ministers of the 27 EU member states recently ensured each other than no financial institution would be left in the lurch. At the moment, there doesn't appear to be a need for any panic bailouts. Financial institutions that have doubts that they will pass the stress tests also appear to have emergency plans prepared.

Part 5: Are the Tests Truly Helpful?

The criteria by which the banks are being tested have been highly controversial in the EU. "The result of that discussion was a political compromise," says Merck-Finck analyst Konrad Becker. The stress scenarios ultimately designed have been harshly criticized by bankers and observers. German banking expert Wolfgang Gerke, for example, believes the test is "too gentle."

And Udo Steffens, president of the Frankfurt School of Finance and Management, doesn't believe the results will be very revealing. "No country can allow for a majority of its banks not to pass the stress test," he says dryly. "And it has been conceived with that in mind."

In addition, it remains entirely unclear which data sets will actually be published. Because of the individual design of the tests, it will be difficult to directly compare the results. They will also be worth little if the precise methods of calculation aren't published as well, argues analyst Becker.

In summing up the sentiment revealed in interviews with top bankers, Germany's Börsenzeitung website writes: the affected bankers don't know anymore whether they should laugh or cry. They remain entirely unclear about the precise criteria that will be used by European banking supervisory organization CEBS to determine whether a bank has "passed" or not.

In the final days before publication, insiders are speaking again and again about the magical 6 percent limit. Under that scenario, the core capital ratio of Germany's three most troubled banks could slip below that line. But Börsenzeitung has reported that the figure for the core Tier 1 capital ratio has not been set in stone.

On the contrary. The website quotes a letter from BaFin to banks that seems almost ludicrous. In it, institutions are asked to provide an "estimate" of "what kind of minimum core capital ratio their houses would need to show -- even under the most adverse scenarios in the EU stress tests -- in order to achieve the desired quieting of the market." In other words, banks are expected to judge for themselves whether they believe their financial resources are sufficient or not.

By now, though, the stoically communicated measure of 6 percent has already become the benchmark that is generally expected by the markets. Experts believe this is a problem. Cologne-based banking professor Thomas Hartmann-Wendels recently warned against the "hype" that has been generated by the stress tests. They are ultimately only one of many indicators "that help to determine how stabile a bank is." Analyst Becker also warns there is a danger that the data will be interpreted "too systematically."

Becker still believes there could be benefits in the test. Stress tests like the one being released on Friday create more transparency in an industry that is normally shrouded in secrecy. It could also ultimately foster greater uniformity in accounting. But more tests must be conducted in the future in order for that to happen. "My great hope is that this will lead to an institutionalization of the procedure," Becker says.

If a new test run were done once every one or two years, it would also solve a further problem: This time, the only one crisis is being staged, one in which the most recent events in Europe are being recreated. It focuses on a scenario in which countries have fallen into financial difficulties. In that sense, its significance is also limited. But future tests could simulate other dangers, Becker says, like a crash of the commodities markets or a collapse of the real estate market in China. That would incrementally expand our knowledge about the stability of our financial institutions.