EU Stress Tests Face Investor Questions on Stringency

Nicolas Sarkozy speaking in Brussels
Nicolas Sarkozy, France's president, speaking in Brussels on Thursday. Photographer: Jock Fistick/Bloomberg

The European Union’s decision to publish the results of stress tests on the region’s lenders was welcomed by shareholders seeking more transparency. Investors still want to know how tough the terms of the tests will be.

The studies will be done “institution by institution,” French President Nicolas Sarkozy told reporters at an EU summit in Brussels yesterday. German Chancellor Angela Merkel said it was important to give “maximum transparency.” Asked how the governments would react if the tests revealed shortcomings, she said the EU has “taken precautions,” including a 750 billion- euro ($928 billion) financial backstop.

“The results could be very helpful reassuring investors that the European financial system is sound,” said Andrew Milligan, the Edinburgh-based head of global strategy at Standard Life Investments Ltd., which oversees about $221 billion. “The devil will be in the detail.”

Merkel and Sarkozy rebuffed concerns from executives including Deutsche Bank AG Chief Executive Officer Josef Ackermann that publishing the tests could undermine confidence in the banks unless governments promise aid. When the U.S. carried out similar stress tests more than a year ago, it pledged to provide capital to banks that couldn’t raise it. The EU still hasn’t disclosed details of its tests, including whether they include a sovereign debt restructuring, raising concern among money managers they may not be stringent enough.

‘Bit Harsher’

“The problem with the stress testing, in most people’s opinion, is fairly serious: It’s not stringent enough,” said Ralph Silva, an analyst at London-based Silva Research Network, which specializes in financial-services firms.

The tests may be “a bit harsher” than similar ones carried out last year, helping to boost market confidence, Morgan Stanley analysts led by Huw van Steenis wrote today. The reviews are “highly likely” to take into account holdings of sovereign bonds, Javier Ariztegui, deputy governor of the Bank of Spain, said in an interview in Santander, Spain, today.

The decision came after Spanish government officials unexpectedly pledged to publish results on individual banks, becoming the first European government to do so. International debt markets have been shut to most Spanish companies and banks as investors lost confidence in the country, Banco Bilbao Vizcaya Argentaria SA Chairman Francisco Gonzalez said June 14.

“Europe needs this because the markets are asking for it,” Gonzalez said at a seminar in Santander, Spain.

‘Could be Misinterpreted’

The difference in yields of Spanish bonds and their German equivalents narrowed after the EU said it would publish the tests. The so-called spread between the 10-year securities fell to 202 basis points as of 12:17 p.m. in London after hitting a euro-area record of 232 basis points yesterday.

Bankers and their lobby groups across Europe had opposed publication. Deutsche Bank’s Ackermann said last week that releasing the stress tests would be “very, very dangerous” if government mechanisms to support European banks weren’t in place beforehand. A spokesman for the bank declined to comment.

Germany’s BdB banking association, which had opposed making the findings public, changed its stance yesterday. It now says publication can “contribute to creating confidence and calming the markets” as long as it doesn’t leave “room for misinterpretation.” In London, the British Bankers’ Association said it still opposes publication of data on individual banks. “The results could be misinterpreted and could lead to a run on a sound bank,” Irving Henry, the BBA’s policy director of prudential capital and risk, said in an interview yesterday.

‘More Confidence’

The wider European stress tests will be published in the second half of July “at the latest,” European Central Bank President Jean-Claude Trichet said yesterday. The EU hasn’t so far disclosed the test criteria. The region’s 25 biggest banks will be examined, according to Andrew Lim, an analyst at Matrix Corporate Capital LLP.

Failure to include sovereign debt exposure would “impact the credibility” of the tests, said Ian Gordon, a banking analyst at Exane BNP Paribas SA in London. “Every piece of withheld data gives skeptics reason to grumble that the tests are not transparent and therefore not meaningful.”

The test criteria should include a possible decline in economic growth, a fall in house prices, the banks’ ability to fund their balance sheets, and a closing of the wholesale money markets, said Jane Coffey who helps manage $51 billion at Royal London Asset Management, including Barclays Plc stock.

“It should give the market more confidence that they are not hiding anything, and that the banks are solidly based, and if they are not, that the problem is in a small enough number of banks,” Coffey said. “Transparency is usually good for confidence. They won’t be doing this if it was going to cause a banking collapse, I would guess.”

‘Region-wide Assessment’

“We need to have a region-wide assessment to quantify and compare the banks -- that’s what this is all about,” said Guy de Blonay, who helps manage about 19.5 billion pounds ($29 billion) at Jupiter Fund Management Plc in London. “Governments want investors to be able to quantify and appreciate the situation on the back of official findings.”

The financial strength of European nations and their banks is closely interconnected, according to Morgan Stanley analysts, who wrote in a June 16 report that countries sharing the euro and their banks are caught in a “vicious circle.”

“Sovereign rating downgrades have eroded confidence in the balance sheets of the banks, most of which own government bonds,” analysts Joachim Fels and Elga Bartsch wrote. “This, together with higher borrowing costs for fiscally challenged countries, has raised funding costs for banks in the interbank market and in the capital markets.”

‘Sovereign Risk’

The EU decision comes more than a year after the U.S. released the results of stress tests it carried out on 19 financial institutions. Publication helped trigger a rally that lifted the Standard & Poor’s Financials Index 36 percent from the start of May through the end of last year. The Bloomberg Europe Banks and Financial Services Index is down 7.4 percent this year. The EU tests may have less impact on markets because of concerns about the level of government debt in Europe, Jupiter’s De Blonay said.

“It’s probably not going to be as positive a reaction as in the U.S. simply because we have an overlay of sovereign risk on the banks in Europe,” he said.

European Central Bank Governing Council member Axel Weber said future stress tests in the banking industry will be more comprehensive than today’s evaluations and may include government bonds. EU states should also provide a backstop “if adverse scenarios materialize,” he said yesterday.

The cost of providing that backstop may still fuel concern among investors that already indebted governments were taking on too much additional borrowing, Standard Life’s Milligan said.

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