Euro banks pass capital test, sort of

Europe’s major banks have complied with demands that they bolster their reserves but only by relying heavily on government aid, accounting techniques, asset sales and methods other than raising cash from investors, the European Banking Authority reported on Wednesday.

The EBA’s new data underscored the troubles still facing Europe’s financial system as banks there cope with an economic recession, a growing number of bad loans and a government debt crisis that has undercut the value of bond holdings central to many bank investment portfolios.

It also may figure into the debate underway in Europe over how to create a regional system for regulating banks in order to stabilize the financial system as a whole. The London-based EBA may play a role in that new regulatory structure, but its handling of bank stress tests last year and its effort to pump up banks’ capital reserves have been widely criticized.

Several of the banks that were ordered last fall to raise fresh reserves have since failed, and others have needed far more funds than the EBA ordered. Spain’s Bankia, for example, was estimated by the EBA to need less than $2 billion. It has since requested more than $20 billion from the Spanish government – pushing the country to seek outside help.

Less than two years old, the EBA coordinates the work of financial regulators throughout the European Union. It does not directly supervise banks but was tasked by European finance ministers to develop stress tests to evaluate the strength of the region’s financial system and oversee the effort to raise bank capital levels.

EBA officials made clear that even this latest report may be flawed. What appeared to be a major disclaimer in the document cautioned that in analyzing each bank, “no assessment of assets quality was undertaken.” The EBA had taken each bank’s word for the value of its investments.

A refusal to realistically account for failed investments has plagued Europe’s banks since the onset of the financial crisis in 2008. Far from the EBA’s aim of “restoring market confidence,” the report demonstrates how deep the problems remain, said Nicolas Veron, an analyst with the Brussels-based Bruegel think tank.

“There was a bit of a random quality to the whole exercise,” Veron said of the EBA’s report. “There were problems at some banks that did need capital and weren’t asked to raise it, and some that were asked to increase their capital that did not really need it.”

Recent events have shown just how much the EBA’s analysis didn’t capture. Along with the money needed for Bankia, Spain has requested about $120 billion from the European bailout fund to rehabilitate its financial system. Little of that was reflected in the various EBA stress tests or the capital increases because the institutions involved were smaller savings banks that were not included in the EBA analyses. Spain’s major banks have all met their capital requirements.

In a report this week, the International Monetary Fund noted a rising number of bad loans at Italian banks, casting doubt on whether they will raise enough new capital to weather the country’s recession.

Still, EBA chairman Andrea Enria characterized the capital increases as “an important step” in strengthening the system. “European banks are now in a stronger position, which should support lending to the real economy,” Enria said in a written statement released with the report.

According to the report, 27 major European banks raised as little as $22 billion in new cash since being ordered by the EBA last fall to boost their capital reserves by about $92 billion total.

Capital reserves are used by banks to absorb unexpected losses, and the EBA ordered the increases last fall under pressure from the IMF, the United States and other nations who felt Europe’s banking system was at risk of a major failure. A bank can improve its capital standing by a number of methods, including shedding loans, changing the accounting treatment of investments and forcing investors who have loaned money to a bank to convert those loans into equity.

According to the EBA report, most of the fresh capital came from those other techniques – along with a healthy dose of government help. The final figures excluded several major bailout programs – including money set aside under an international rescue to rehabilitate Greece’s banks, Spain’s rescue of Bankia, several smaller government rescues in countries such as Slovenia, and the costs associated with the break-up of the Franco-Belgian Dexia bank.

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