European Stress Tests Said to Outline Three Scenarios

European regulators plan to detail three scenarios when they publish the results of their stress tests on the region’s banks this week, according to a document by the Committee of European Banking Supervisors.

Banks will publish their estimated Tier 1 capital ratios under a benchmark for 2011, an adverse scenario and a third test that includes “sovereign shock,” according to a template prepared by CEBS for the banks and obtained by Bloomberg News.

In the last scenario, banks will publish their estimated losses on sovereign debt held in their trading book as well as “additional impairment losses on the banking book” that they may suffer after a sovereign debt crisis, according to the document dated July 15.

Under accounting rules, banks have to adjust the value of sovereign bonds held in the trading book according to changes in market prices, said Konrad Becker, a financial analyst at Merck Finck & Co. in Munich. For government debt held in the banking book, lenders must write down their value only if there is serious doubt about a state’s ability to repay its debt in full or make interest payments, he said.

The sovereign-shock scenario doesn’t assume a European nation will default, said a person with knowledge of the matter, who spoke on the condition of anonymity because the information is private. Instead, it will assume that rising government-bond yields will push up borrowing costs, spurring defaults in the private sector that would lead to losses in lenders’ banking books, said the person.

EU Stress Tests

CEBS coordinates national banking authorities and makes policy recommendations to the European Union on regulation. Spokeswoman Efstathia Bouli declined to comment.

EU regulators are examining the strength of 91 banks to determine if they can survive potential losses from both a recession and a decline in the value of their government bond holdings. They are using the tests to reassure investors about the health of financial institutions from Germany’s WestLB AG and Bayerische Landesbank to Spanish savings banks as the debt crisis pummels the bonds of Greece, Spain and Portugal. The results will be published at 6 p.m. Brussels time on July 23.

The banks may publish how much they will need to raise in capital if their Tier 1 ratio, a key measure of financial strength, falls below 6 percent under the sovereign scenario, the draft shows. Lenders will also provide estimated loss rates for their corporate and retail holdings for the adverse cases, according to the template.

‘Underwhelming’ Results

The test results are likely to be “underwhelming” because they may require banks to raise less than half the 75 billion euros ($97 billion) of fresh capital needed, Nomura Holdings Inc. analysts said in a report yesterday. Hypo Real Estate Holding AG, the commercial-property lender rescued by the German government following the financial crisis, has failed the test, two people familiar with the results said this week.

“Many people are adopting a dubious, or a sort of doubting approach to the whole thing,” said Goldman Sachs Group Inc. Chief Global Economist Jim O’Neill in a Bloomberg Radio interview today.

It’s difficult to apply the same tests to banks ranging from Spain’s “top class” Banco Bilbao Vizcaya Argentaria SA to Germany’s state-owned Landesbanken, which are tools of the country’s postwar development, he said. In terms of the European debt crisis, it would have been better if regulators had concentrated on testing Spanish banks, he said.

To contact the reporters on this story: Meera Louis in Brussels at mlouis1@bloomberg.net; Jann Bettinga in Frankfurt at jbettinga@bloomberg.net

To contact the editors responsible for this story: Frank Connelly at fconnelly@bloomberg.net; James Hertling at jhertling@bloomberg.net.

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