EU Stress Tests Limited to Banks’ Trading Book Losses

The tests will assume a loss of 23.1 percent on Greek debt
European Central Bank president Jean-Claude Trichet. Photographer: Hannelore Foerster/Bloomberg

European Union stress tests are set to ignore the majority of banks’ holdings of sovereign debt after regulators decided against testing securities held in their banking books.

“The haircuts are applied to the trading book portfolios only, as no default assumption was considered,” the European Central Bank said in a confidential document July 22 entitled “EU Stress Test Exercise: Key Messages on Methodological Issues.”

Lenders hold about 90 percent of their Greek government bonds in their banking book and 10 percent in their trading book, according to a survey by Morgan Stanley analysts led by Huw van Steenis. They only have to write down the value of bonds in their banking book if there is serious doubt about a state’s ability to repay its debt in full or make interest payments.

“The tests need to be across the board -- including the banking book,” said Andrea Williams, who manages about 1.1 billion pounds ($1.69 billion), including BNP Paribas SA and Credit Suisse Group AG shares, at Royal London Asset Management in London. “It does undermine the whole credibility of the tests.”

The stress tests will assume a loss of 23.1 percent on Greek debt, 14 percent on Portuguese bonds, 12.3 percent on Spanish debt, and 4.7 percent on German state debt, according to the document obtained by Bloomberg News. U.K. government bonds will be subject to a 10 percent haircut, and France 5.9 percent.

‘Interest Rate Shocks’

The tests assume the weighted average yield on euro-area five-year government bonds will rise to 4.6 percent in 2011 from

2.7 percent at the end of 2009. The tests also include an increase in the yield on five-year Greek government bonds to as much as 13.9 percent after “interest rate shocks,” the document shows.

“The haircuts on government debt in the trading book increase according to the introduction of sovereign risk, which is modeled as an increase in government bond spreads in line with market developments since the beginning of May 2010,” according to the document.

The decision “allows banks to basically underestimate their exposure to distressed peripheral debt,” Win Thin, a senior currency strategist at Brown Brothers Harriman in New York, wrote in a note to clients today. “By leaving out stress tests on the banking book, then a true picture of bank balance sheets will clearly not be obtained.”

Accounting Rules

Under accounting rules, banks have to adjust the value of sovereign bonds held in the trading book according to changes in market prices. For government debt held in the banking book, lenders must write down the value only if there is serious doubt about a state’s ability to repay its debt in full or make interest payments.

The bank stress test scenarios also include securitized debt products being downgraded four levels by credit ratings companies, a 20 percent fall in the value of European equities in both 2010 and 2011 and tests in 50 other macroeconomic parameters, according to the Committee of European Banking Supervisors, which is overseeing the tests.

European Union Regulators examined the effect on banks’ balance sheets of an increase in short-term interest rates of 125 basis points. Banks’ overall liquidity wasn’t tested because it might clash with studies being carried out by the Basel Committee on Banking Supervision while it decides on the details of new capital requirement rules.

Sovereign-Bond Holdings

Regulators are examining the strength of banks to determine if they can survive potential losses on sovereign-bond holdings. They are counting on 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 54-member Bloomberg Europe Banks and Financial Services Index traded up 0.18 percent at 4:30 p.m. London time. The euro weakened against the dollar, sliding 0.46 percent to $1.2847.

CEBS is scheduled to release the criteria and the results from 5 p.m. London time today. CEBS deputy secretary general Patrick Amis declined to comment on the document, referring questions to the ECB. The ECB declined to comment.

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