EU stress tests: banking on capital Premium

Banks requiring capital face a tougher test

A sign saying “beware of dog” is a deterrent to would-be thieves – even if the dog is really a chihuahua. EU stress tests – designed to work out how banks would fare if all hell breaks loose again – have had a galvanising impact on the sector. And they have not yet begun. The European Banking Authority, one of the EU’s fleet of regulators, says that banks have raised about €25bn in core tier one capital since September. Austria’s Raiffeisen and Greece’s Piraeus and Alpha are among those that have tapped the equity markets.

On Tuesday, the EBA showed how big and scary its dog will be. It is no chihuahua. The adverse scenario for 2014-16 includes jumps of over 110 basis points per year in government bond yields, a 21 per cent decline in house prices, a 15 per cent fall in commercial property prices, and a sharp recession. GDP growth would be 7 per cent below the EU’s base scenario. Some of the local regulators that will be applying the tests have been more extreme – UK authorities are modelling a 35 per cent drop in house prices. Woof.

It could all have been worse. A one-fifth drop in equity prices, for example, sounds bad but the MSCI Europe almost halved in 2008. And the fall in GDP is not as severe as the US authorities used in their tests. But this is a delicate process. If the tests are too tough, banks would either have to demand more capital en masse or shrink their balance sheets until their capital ratios look better. If the tests are too lenient, confidence would be hurt. Europe has form here – the 2011 stress tests passed Bankia and SNS Reaal, both of which subsequently needed bailing out. The latest US tests – with which both Citigroup and Bank of America have struggled – provide a better template. Capital laggards such as Deutsche Bank should be ready to throw regulators some big, meaty bones.

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