EU Tests May Be ‘Missed Opportunity’ to Fortify Banks

European Central Bank Vice President Vitor Constancio
Vitor Constancio, governor of the bank of Portugal and European Central Bank vice president-elect, listens at a press conference in Lisbon. Photographer: Mario Proenca/Bloomberg

European Union stress tests found banks need to raise 3.5 billion euros ($4.5 billion) of capital, about a tenth of the lowest analyst estimate, leaving doubts about whether regulators were tough enough.

“The stress tests are a helpful step forward in a number of areas,” Huw van Steenis, head of European banks research at Morgan Stanley in London, said on a conference call yesterday. “But they are not going to be the game changer that we were really hoping and in some cases are a missed opportunity.”

European banking shares rose after the tests found that only Germany’s Hypo Real Estate Holding AG, Agricultural Bank of Greece SA and five Spanish savings banks lacked adequate reserves to maintain a Tier 1 capital ratio of at least 6 percent in the event of a recession and sovereign-debt crisis, according to results published July 23. The banks that failed the stress tests are in “close contact” with national authorities over how they will raise capital, said the Committee of European Banking Supervisors, which ran the assessments of 91 lenders.

“The worst fears have not been realized,” said Mike Lenhoff, chief strategist at London-based Brewin Dolphin Securities Ltd., which oversees $33 billion. “Nobody would say we are looking at a complete and utter disaster here in the euro-zone banking system.”

Allied Irish Banks Plc, Dexia SA and Societe Generale SA led European bank stocks higher. The 54-company Bloomberg Europe Banks and Financial Services Index rose 0.5 percent.

‘Work to Do’

Had the Tier 1 threshold been 7 percent, 24 of the banks would have failed, said Andrew Sheets, Morgan Stanley’s head of European credit strategy in London, on the conference call. For some, there is “serious work to do,” he said.

Italy’s Monte dei Paschi di Siena SpA, Spain’s Banco Pastor SA and Bankinter SA, and Germany’s Deutsche Postbank AG were among 17 banks that showed a drop in their capital ratio to between 6 percent and 7 percent under the toughest scenario, according to figures released by CEBs.

Bankinter is sufficiently capitalized, Finance Director David Perez Renovales told Bloomberg Television today. Banco Pastor’s capital levels are adequate for now, a spokesman for the bank said. Monte dei Paschi said on July 23 the test’s adverse scenario shouldn’t be considered as “representative of the current situation or possible present capital needs.” Postbank plans to boost reserves with earnings, spokesman Joachim Strunk in Bonn said today.

No Surprises

Before the results were published, analysts at Nomura Holdings Inc. estimated the banks would have to raise 30 billion euros. Goldman Sachs Group Inc. predicted they would need 38 billion euros and Barclays Capital said they would require as much as 85 billion euros. Tests carried out in the U.S. last year found that 10 lenders, including Bank of America Corp. and Citigroup Inc., needed $74.6 billion.

“If we had at least one bank which the markets hadn’t really expected to fail, that would have given the stress tests more credibility,” said Lothar Mentel, chief investment officer at Octopus Investments Ltd. in London, whose team manages more than 600 million pounds ($926 million). “That hasn’t happened.”

The European tests ignored the majority of banks’ holdings of sovereign debt. Regulators don’t believe there will be a national default, European Central Bank Vice President Vitor Constancio said July 23. The evaluations took into account potential losses only on government bonds the banks trade, rather than those they are holding until maturity, CEBS said.

Sovereign Stress

“The fact that they did not stress the bank book is going to be seen as a weakness,” said Robert Talbut, chief investment officer at Royal London Asset Management Ltd., which oversees about $52 billion. “I don’t think the results of the tests will resolve anything.”

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. They have to write down the value of bonds in their banking book only if there is serious doubt about a state’s ability to repay in full or make interest payments.

Twenty-four banks would have fallen below the 6 percent capital threshold had the test included losses on sovereign debt held in banking books, Citigroup Inc. analysts led by Ronit Ghose said in a note to clients. The combined capital deficit of those banks would have reached 15 billion euros, they said.

Citigroup said that 85 banks provided breakdowns of their government-debt holdings when they published the stress test results. The six that didn’t are all German banks and include Deutsche Bank AG, the country’s biggest bank, Citigroup said.

Capital Already Raised

The stress tests assumed 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 CEBS. U.K. government bonds were subject to a 10 percent haircut and France 5.9 percent, CEBS said.

The stress tests are rigorous enough to be taken seriously, Credit Suisse Group AG analysts led by Daniel Davies said in a report. Banks passed because the European industry has raised 220 billion euros in the last 18 months to bolster capital, they said.

The Credit Suisse analysts found that the majority of banks still passed the tests when they were reengineered to include bigger haircuts on sovereign debt and better quality capital. Under those more rigorous tests, seven Greek banks and KBC Groep NV would fail.

“The criteria used by CEBS created a level playing field for all 91 banks,” Viviane Huybrecht, a spokeswoman for KBC in Brussels, said by phone. “If you now come up with other criteria then of course you end up with other results.”

Funding Markets

Calls to Alpha Bank AE, National Bank of Greece SA, Hellenic Postbank SA, EFG Eurobank Ergasias, Bank of Cyprus Pcl and Piraeus Bank SA out of office hours were not immediately returned.

The tests will be seen as “broadly successful” if the funding markets continue their recovery, said Arturo de Frias, a London-based analyst at Evolution Securities. The exams are “much more aimed at restoring confidence of bond investors and providers of short-term liquidity than for equity investors,” he said.

The cost of borrowing in euros for three months rose to the highest level in almost a year today. The euro interbank offered rate, or Euribor, advanced less than one basis point to 0.889 percent today, the most since July 31, 2009, data from the European Banking Federation showed. The rate climbed for the 41st consecutive day, the data showed.

‘Safe to Invest’

European governments aimed to use their first coordinated stress tests to reassure investors about the health of financial institutions after the debt crisis pummeled the bonds of Greece, Spain and Portugal. Mounting budget deficits in those countries raised concern that they won’t be able to pay their debts.

“The results give you the go-ahead that it’s safe to invest in banks,” said David Serra, co-founder of Algebris Investments, a fund manager which has shares in Societe Generale SA and Banco Santander SA. “We have just had one of the biggest crises and the message from these tests is that the banking system can withstand a double dip.”

The U.S. stress tests carried out last year were criticized at the time for being too soft. Yet the evaluations on 19 banks helped persuade investors that the financial system was sound, contributing to a 36 percent rally in the Standard & Poor’s Financials Index in the following seven months.

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