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 EU 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.

Regulators “will be setting a more stringent capital benchmark,” the European Banking Authority said in a statement today.

0.5 Percent Contraction

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, according to documents obtained by Bloomberg News. 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 EBA will announce the methodology for calculating the results of the stress tests in April, the agency said last week. The EBA said the documents weren’t final.

“My team at the EBA have worked hard with national authorities,” the European Central Bank and “the European Commission to develop a detailed methodology which is meaningful and should be consistently implemented across the banks participating in this years’ exercise,” Andrea Enria, chairman of the EBA, said in a March 4 letter to banks obtained by Bloomberg News.

The exams will also test the effect of a 75 basis-point-jump in European sovereign bonds and an increase in short-term interbank financing costs of 125 basis points.

91 Lenders

Ninety-one lenders were tested with a pass rate set at 6 percent of Tier 1 capital last year. Anglo Irish Bank Corp., whose collapse during the financial crisis contributed to Ireland seeking an international bailout, wasn’t among the lenders tested. This year’s tests will involve 88 banks, according to the documents.

“You need to look at the whole package of what is in the new stress tests,” Enria said in an e-mailed statement today, “not just pick on a few points out of context.”

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 be phased in starting in 2013.

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

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