Bank stress tests to shed light on Europe's economic health

By Howard Schneider
Saturday, July 17, 2010

From bankrupt Spanish housing projects to Ireland's crashing export economy and the turmoil caused by Greece's debt crisis, Europe's banks have been taking a beating.

How much of one, no one quite knows. But the question has become central in the broader debate about how to reform the global financial system -- and critical to whether markets on both sides of the Atlantic get healthier in coming months.

Late next week, European regulators are due to announce the results of tests on 91 European banks, representing much of the European economy. The tests are designed to see how they would respond to another round of economic shock -- whether they have enough capital, whether they have cleansed their books of bad debts and whether their business strategies are viable.

The results could well show that European banks need tens of billions of dollars in help, a prospect that could further dim growth in an already lagging part of the world economy and force banks and their host governments to present a clear plan for paying the tab.

'So much uncertainty'

As a whole, Europe's banks have not raised as much new capital as U.S. firms since the crisis. They have also been slower to write off bad loans and have been entangled in local and regional problems whose overall impact remains unclear. The International Monetary Fund in particular has criticized their continued reliance on government funding and short-term help from the European Central Bank as merely delaying an inevitable reckoning.

"The banks' exposure to sovereign debt, the banks' losses, their exposure to property markets . . . there is so much uncertainty at the moment," said Diego Iscaro, a senior economist with the IHS Global Insight consulting firm.

The tests in Europe are modeled after the stress tests that proved to be an important step in calming U.S. markets at the depth of the crisis, when the similar studies of American banks showed them in better shape than many thought.

The hope is that the same will happen in Europe, quelling some of the doubts about the European economy raised when Greece appeared headed for a default on its bonds and required emergency help from the IMF. European authorities have conducted broad stress tests in the past and say that, judged as a whole, their financial system passed muster.

But as the crisis over Greek government debt unfolded in the spring, the United States, the IMF and others pushed for Europe to do both company-specific studies and to release the detailed results in an effort to give reassurance that, for example, a default by Greece would not lead to a string of failures among banks that owned Greek bonds.

In this case, the process is raising its own set of uncertainties. Details of the scenarios being used to test each bank's health have not yet been released, and some analysts worry that they don't include true worst-case events -- the onset of another recession, for example, or a full-blown national default.

In addition, in the U.S. case, it was clear that the banks and the federal government would come up with a recapitalization plan if needed. But no one is certain how that will be handled among a disparate collection of European countries with differing economies, differing corporate cultures and differing levels of public patience for what may be another round of bailouts.

A recently established, trillion-dollar fund set up by the European Union and the IMF to help stabilize highly indebted European governments has been declared off-limits for direct recapitalization of banks. European officials have said that individual governments will have to step forward for help if their banks can't raise enough on their own.

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