EU Stress Tests Updated for Worse Losses on Sovereign Debts

The European Banking Authority updated its stress tests to take into account extra trading losses that banks may face on their holdings of sovereign debt from crisis-hit European Union countries including Greece.

Rules for how banks should write down the value of government bonds they plan to trade “have been adjusted, in some cases, to reflect market developments,” the EBA said in an e-mailed statement today. The writedowns should “reflect actual losses that are related to market values.”

The changes are an attempt to give a more realistic picture of banks’ vulnerability after European Central Bank President Jean-Claude Trichet said yesterday that risk signals for financial stability in the euro area are flashing “red.”

“Clearly they have to make these tests credible and credibility means you have to stress relative to current market conditions,” Neil Smith, a banking analyst at WestLB AG, said in a telephone interview today. If the Greek situation has deteriorated “then it’s sensible in my view to add a bit more stress for Greece,” Smith said.

The EU has failed to tame a sovereign debt crisis that is entering its 21st month and has included bail-outs of Greece, Ireland and Portugal. At a Brussels summit tonight and tomorrow, the region’s leaders will debate the size of new loans to the Athens government and how to get holders of Greek bonds to contribute.

The EBA “is closely monitoring the situation and the difficult financing circumstances in Greece,” it said. “The stress test results will allow an assessment of potential systemic impacts stemming from the current market conditions on sovereign risk and banks’ cost of funding.”

Stricter Capital Measure

Under this year’s EU stress tests, 91 banks will be expected to maintain a Core Tier 1 capital ratio of at least 5 percent. That capital measure is stricter than last year’s assessment, which had a pass rate of 6 percent Tier 1 capital, a measure of financial strength that encompasses a broader range of securities. Last year’s tests were criticized for not testing how banks would fare against a sovereign default -- a factor that hasn’t been changed in this year’s scenario.

Extra guidance was sent to banks at the beginning of the month “to reflect the worsening of the sovereign situation,” EBA spokeswoman Franca Rosa Congiu said in a phone interview today. This was required because of “inconsistencies” in data submitted by lenders and because some of it was deemed by the EBA to be “too optimistic,” she said.

“This helps explain the delay to July, from the initial mid-June deadline, for publication of the stress test results,” Michael Symonds, an analyst at Daiwa Capital Markets, said in an e-mail.

Presumed Losses

Banks were told to adjust the presumed losses they will face on government bonds that they intend to trade. The London-based EBA also changed the rules for how banks should calculate their provisions against a default on sovereign debt they will hold to maturity, said Congiu.

This year’s tests will include a review of how banks would handle a 0.5 percent economic contraction in the euro area in 2011 as well as a 15 percent drop in European equity markets.

The EBA tests will also examine the effect of a 75 basis-point jump in interest rates on European sovereign bonds and an increase in short-term interbank financing costs of 125 basis points.

While the stress tests don’t assume a government default, they do require banks to “assess risks against sovereign debt” by measuring the probability that a nation fails to meet its obligations, the EBA said.

The new guidelines seek to prevent inconsistencies or “excessive optimism” in how these risks are calculated, the EBA said, including by restricting assumptions that banks can make about changes to credit ratings.

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