Will the 2011 Stress Test on European Banks Restore Confidence in Europe's Financial Markets?

Sources: FT: EBA Chief Stresses Rigour of New Bank Tests; Deadline Set for EU Countries' Failing Banks Plan; EU Bank Stress Tests
WSJ: Why European Banks Are Stressed Out; Europe Blinks on Bank Test

Recently, the European Banking Authority (EBA) unveiled its scenarios and methodology for the 2011 stress test for European banks. The test is designed to evaluate how resilient banks are to adverse external shocks, and tries to identify weaknesses and actions needed to correct those weaknesses. However, last year's test was considered a "bad joke." Among 91 banks, only 7 banks failed the test and only one of them, Deutsche Bank, responded to the test results by raising substantial fresh capital. Also, Ireland's banks which had also passed the test collapsed and had to be bailed out.

Andrea Enria, the chairman of the EBA, emphasizes that the 2011 test will be "more severe" than last year's test. According to the EBA, this year's worst-case scenario assumes lower growth rates, higher interest rates, lower housing prices and further decline in sovereign debt values. For instance, the scenario assumes a 0.5 percent fall from the baseline scenario in eurozone gross domestic product (GDP) and a 0.2 percent fall in 2012. In addition, unlike last year, this year's test results are subject to "peer review" by the EBA and other regulators. Mr. Enria said that the EBA will "ensure the credibility and consistency of the exercise using both statistical benchmarks and expert judgment." Mr. Enria also said that each country should have plans to recapitalize failing banks and it would be "sensible" to set a deadline on failing banks to raise new capital.

However, there are concerns that this year's test may repeat last year's mistakes and fail to restore confidence in Europe's financial markets. Critics point out the fact that each country again will use its own definition of the Tier 1 capital ratio (a measure of a bank's strength to absorb losses), which will make it difficult for investors to compare the resilience of banks in different countries. Also, although sovereign debt restructuring is expected to happen, especially in Greece and Ireland, the test will not assess significant amounts of sovereign debt holdings in European banking books.

This year, 88 banks in 20 European countries will be tested and the results will be available in late June.