Stress Tests on EU Banks Must Assess Sovereign Risk, Draft Says

Stress tests on European Union banks should assess sovereign-debt risks when calculating how lenders would perform against shocks to the banking system, according to a draft EU document.

Finance ministers from the 27 EU countries, who will discuss the stress tests at a meeting in two weeks, also will ask the Committee of European Banking Supervisors, which is conducting the EU-wide exercises, to extend them to include a “significant market share of institutions” in each nation, according to the draft, which was obtained by Bloomberg News. The paper, dated June 25, was prepared for a July 12-13 meeting of EU ministers in Brussels.

Questions have arisen over whether the stress tests would take into account risks tied to the sovereign debt of Greece, Portugal and other European nations. Marking down the value of Greek bonds, even for the purposes of a test, might imply that regulators perceive a debt default as a possibility, which could further unsettle investors, according to analysts.

The EU has pledged about $1 trillion to reassure the markets and backstop the euro, which has fallen 14 percent against the dollar this year on concerns that Greece’s debt crisis is spreading. The extra yield investors demand to hold Greek 10-year bonds over benchmark German bunds has jumped to about 800 basis points, almost five times the level a year ago. European banking stocks declined 3.2 percent today.

Photographer: Simon Dawson/Bloomberg

Former co-Chief Executive Officer of JPMorgan Chase & Co.’s investment bank William Winters pauses during a television interview in London. Close

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Photographer: Simon Dawson/Bloomberg

Former co-Chief Executive Officer of JPMorgan Chase & Co.’s investment bank William Winters pauses during a television interview in London.

Banks’ Holdings

Investor concern that Greece’s fiscal crisis is spreading to other EU countries such as Italy, Spain and Portugal has increased those governments’ borrowing costs and raised questions about banks’ holdings of sovereign debt. European banks had $2.29 trillion at risk in Greece, Italy, Portugal and Spain at the end of 2009, according to the Bank for International Settlements.

Bill Winters, the former co-chief executive officer of JPMorgan Chase & Co.’s investment bank, said on Bloomberg Television on June 25 that the main issue for the stress tests is whether they will include restructuring of sovereign-debt holdings in the results.

“The question everybody’s asking is: Are you going to include scenarios that involve the restructuring of Greek or another countries’ debt in these stress tests?” Winters said. “If you do include it, we already know the answer: There are real issues. If you don’t include it, we’re not sure we’re going to take that test very seriously.”

100 Lenders

Seeking to demonstrate that Europe’s financial system can withstand shocks, EU leaders on June 17 agreed to disclose how banks perform in the stress tests in the second half of July. The tests, which so far include only large cross-border banks, may be extended to 100 lenders, European Central Bank Governing Council member Axel Weber told German lawmakers on June 25, according to Hans Michelbach, deputy finance spokesman in parliament for the Christian Democrats.

According to the draft EU paper, “appropriate and common methodology should be devised as soon as possible in order to assess the resilience of banks, including the exposures to sovereign risk, matching closely market concerns regarding the exposures.” The paper is titled “Stress test exercise - Draft Mandate to CEBS.”

Spanish Finance Minister Elena Salgado said today that the tests will make clear that her nation’s banks are strong. Spain will ask European finance ministers at the July 12-13 meeting to publish the results as soon as possible, she said.

Solvency Position

“At the next Ecofin meeting in two weeks, Spain’s request will be for our stress tests to be published immediately, to show that our whole banking system has an excellent solvency position,” Salgado said in an interview with Cadena Ser radio in Madrid.

“The banking industry worldwide is still in dreadful” shape after the global financial crisis, Ralph Silva, an analyst at London-based Silva Research Network, which specializes in financial-services firms, said in an interview today with Bloomberg Television. Still, “we do have some solid banks and that should form the foundation for the recovery.”

Billionaire investor George Soros said last week that it would be impossible to judge the state of the European banking industry without including “the smaller banks, notably the cajas in Spain and the Landesbanken in Germany,” in the stress- testing exercise. Continental European banks haven’t been “properly cleansed” after the credit crisis, Soros said in a speech in Berlin on June 23.

Bank-Rescue Fund

Germany’s state-owned regional Landesbanken and savings banks will probably write down $143 billion for the years 2007 to 2010, the International Monetary Fund said in April. Spanish savings banks may borrow around 10 billion euros from the country’s bank-rescue fund, Bank of Spain Governor Miguel Angel Fernandez Ordonez told lawmakers in Madrid on June 22.

A gauge of European bank stocks in the Stoxx Europe 600 Index fell 2.5 percent today to the lowest since June 11.

With the stress tests, “CEBS should extend the exercise, in close cooperation with the ECB, to a wider share of the EU banking system also covering relevant financial institutions, and more member states, with a view to representing a significant market share of institutions in all countries involved,” according to the EU document. London-based CEBS coordinates national banking authorities and makes policy recommendations to the EU on regulation.

“Individual banks’ results of the extended stress test will be simultaneously disclosed to the public during the second half of July 2010, with the consent of the banks concerned, as well as the methodology, with details on macroeconomic scenarios and loss rates,” according to the draft document.

To contact the reporter on this story: Meera Louis in Brussels at mlouis1@bloomberg.net

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