Stress tests of Europe's finances finds most major banks in good health

Seven European banks would not be strong enough to withstand another recession according to tests designed to revive investor confidence.
Washington Post Foreign Service
Saturday, July 24, 2010

LONDON -- A broad probe into the health of Europe's financial sector found virtually every major bank in the region fit to withstand severe economic shocks and declared only a handful of smaller institutions at risk.

The long-awaited tests were aimed at assuaging fears of a European banking crisis. The Europeans followed in the footsteps of U.S. officials who last year conducted probes into the health of American banks, forcing almost half of those examined to beef up reserves. Just as the U.S. banks suffered from piles of bad debt from mortgage-backed securities and other credit-bubble excesses, banks in Europe have come under scrutiny for their holdings of government bonds from near-bankrupt nations such as Greece.

The results are comforting on the surface, providing the first evidence that Europe's banking sector may be stronger than some had feared. But skeptics said the clean bill of health given to so many of the region's banks -- only seven out of 91 banks tested were told to increase reserves -- raised serious questions about whether the tests had been strict enough. While the results may not panic investors, they may not reassure them, either. Traders showed their early skepticism by selling off the euro in late trading in New York when the results were published after the close of markets in Europe.

One major flaw in the testing, analysts said, is that it did not envision what would happen to the banks in the event of a full-fledged debt default in nations such as Greece or Spain. Estimations of potential losses were based only on each bank's holdings of government debt they are seeking to trade -- not those they are holding on to as long-term collateral.

"I think it's disappointing," said Fahd Rachidy, head of global investment for London-based Vantage Capital Markets. He said the real concern in Europe right now centers on the risk of countries going bankrupt. Not factoring that possibility into the tests "goes to show you that the tests were not credible enough," Rachidy said.

The European Union, severely criticized for a slow response to the debt crisis in the region, insisted Friday in a statement that the results "confirm the overall resilience" of Europe's banking system. To be sure, the tests yielded few surprises -- with the weak links being five regional banks, or cajas, in troubled Spain; Greece's ATE bank; and Hypo Real Estate Holding AG, a nationalized bank in Germany. Together, their shortfalls under the most dire economic conditions considered by the tests would amount to a modest $4.5 billion. That number is lower than several analysts have predicted.

"The results and the actions that have been announced to address bank capital deficiencies promise to significantly strengthen the European financial system," said Dominique Strauss-Kahn, managing director of the International Monetary Fund, which has criticized Europe's response to the weaknesses of the banking sector.

Christine Lagarde, France's finance minister, told reporters in Paris that the tests had been tough. "I would suggest that those results should be very credible and should raise the confidence in European banks," she said, according to the Associated Press.

The prospect of a banking crisis in Europe, where financial institutions have been hit by fears of debt defaults in a number of nations, including Spain and Portugal, has emerged in recent months as a potential threat to the global economy. Some analysts insisted that the tests gave them little reason to assume that threat had passed. Yet others said that, in some respects, the European tests had been tougher than those used by U.S. regulators during the height of the financial crisis. For instance, the Europeans considered severe economic conditions -- including a fall back into recession -- despite new evidence from Germany, France and Britain that the economic recovery is beginning to take root in the region.

"Yes, this stress test has holes, but they still turned out to be stronger than many believed they were going to be," said Ralph Silva, director of Silva Research Network, a London-based banking advisory firm. "We thought it was going to be a token affair, and despite the criticism it really wasn't."

The United States conducted a stress test of the 19 largest U.S. banks in spring 2009, now viewed as a key step in stabilizing the financial system amid the crisis. Federal bank regulators projected what losses each large bank would incur if the economy performed even worse than was expected, with a steep rise in unemployment and a big drop in home prices.

The regulators then required that banks raise enough capital to ensure they could withstand that adverse economic scenario. They announced the results -- the new capital, if any, needed by each bank -- in May 2009. They found that 10 of the 19 banks needed to raise new capital, which they did largely by going to private markets. Raising private capital would have been all but impossible a few months earlier, but the stress tests made investors more confident that investing in the banks would be safe.

The exercise played a key role in helping to stem the financial crisis. And it set the stage for an end to the recession in summer 2009 by removing a layer of uncertainty about the stability of the banking system.

Staff writer Neil Irwin contributed to this report from Washington.

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