EU Said to Discuss Tough Capital Pass Rate for Stress Tests

European Union regulators are discussing plans to prevent banks from using so-called hybrid capital to determine the results of this year’s EU stress tests, two people familiar with the negotiations said.

Regulators could hold banks to a stress test passing grade of 5 percent of core Tier 1 capital excluding hybrid capital, such as junior bonds and preference shares, said the people, who declined to be named because the talks are private.

“This would give you some slightly random answers,” Simon Gleeson, a financial regulation lawyer at Clifford Chance LLP said in an interview in London today. “What you are doing is penalizing banks for some fund raising decisions they may have made two to three years ago,” he said.

Last year’s European Union stress tests were criticized for not being stringent enough because lenders in the 27-nation region were shown by regulators to need only 3.5 billion euros ($4.8 billion) of new capital, about a 10th of the lowest analyst estimate.

Ninety-one lenders were tested with a pass rate set at 6 percent of Tier 1 capital. Anglo Irish Bank Corp., whose collapse during the financial crisis contributed to Ireland seeking an international bailout, wasn’t among the lenders tested.

Hybrid Rules

Scenarios for this year’s test will include a 0.5 percent economic contraction in the euro area in 2011 and a 15 percent drop in European equity markets, Reuters reported earlier. Banks will also have to simulate a loss of 3.5 percent on German 10- year bonds and 7.6 percent on British debt on assets held in their trading book.

The Basel Committee on Banking Supervision decided in January to impose stricter rules on banks’ use of hybrid capital because it didn’t provide a buffer for losses in the 2008 financial meltdown. The rules will come into effect in 2013.

The European Banking Authority will announce the methodology for calculating the results of the stress tests in April, the agency said last week.

EBA spokeswoman Franca Rosa Congiu declined to comment on the stress test methodology.

To contact the reporters on this story: Ben Moshinsky in London at bmoshinsky@bloomberg.net;

To contact the editor responsible for this story: Anthony Aarons at aaarons@bloomberg.net

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