April 25 (Bloomberg) -- European Union officials are preparing to pit the bloc’s banks against the toughest simulated recession that they have ever faced in a stress test, three people briefed on the matter said.
The European Banking Authority and the European Central Bank will next week unveil an adverse scenario for the stress tests, which start in May, that assumes the 28-nation bloc’s economy undershoots EU growth forecasts by a greater margin than in the exams held in 2010 and 2011, said the people, who declined to be named as the details aren’t yet public. Those previous tests were criticized for failing to uncover weaknesses at banks that later failed.
This time around, the stress test’s adverse scenario is predicated on economic output that misses the European Commission’s growth forecasts by 2.2 percentage points in 2014, 3.4 points in 2015 and 1.4 points in 2016, the people said. That probably translates into two years of recession followed by anemic growth in the last year covered by the exercise. The EBA plans to announce the details in London on April 29. A spokesman for the EBA and a spokeswoman for the ECB declined to comment.
“These are really very, very unlikely scenarios,” said Ricardo Wehrhahn, who helped conduct Spanish stress tests in 2012 and is now Madrid-based managing partner at Intral Strategy Execution. “We are at the turning point of the economic cycle, so assuming that growth will miss like this is very stringent,” he said. “This will give confidence to the market that the banks that pass these tests are in a solid condition.”
The ECB is running an assessment of 128 banks from Deutsche Bank AG to Bank of Valletta Plc as it prepares to assume full oversight of euro-area lenders in November, seeking to prevent a repeat of the financial crisis that threatened to splinter the currency bloc. The exam, which applies to banks in the entire EU, requires banks to maintain a capital pass mark of 5.5 percent of risk-weighted assets.
The 43-member Bloomberg Europe Banks and Financial Services Index fell 1.4 percent as of 1:15 p.m. in Frankfurt to the lowest since April 15. National Bank of Greece SA, Vienna-based Raiffeisen Bank International AG and Societe Generale SA led the decline.
The ECB has said the baseline for the scenario will be formed around the commission’s spring economic forecasts, which are due to be published in May and provide an outlook for 2016 for the first time. The commission’s winter forecasts, which officials have used in advance of the new numbers being available, assume EU growth of 1.5 percent this year and 2 percent in 2015.
The current scenario foresees unemployment rising in each of the three years, overshooting the baseline forecast by 0.6 percentage point in 2014, 1.3 points in 2015 and one point in 2016. That would simulate EU-wide unemployment exceeding its highest-ever annual average level of 10.8 percent last year.
Regulators are trying to avoid comparisons with the last EU-wide stress tests in 2011, which were criticized for failing to spot problems at banks that later failed. The exams modeled the effect of a fall in output of 0.4 percent in 2011, or a 2.1 percentage point deviation from a baseline growth rate of 1.7 percent, followed by a year of static growth in 2012.
The adverse scenarios were overtaken by reality. Economic activity fell 0.4 percent in 2012, according to data compiled by Eurostat.
The ECB and EBA exercise will likely also be compared to a recent stress test conducted by the U.S. Federal Reserve, in which one bank failed outright and other lenders flunked assessments of their capital planning. Under the Fed’s worst-case scenario -- where U.S. GDP doesn’t grow or contracts for six straight quarters, unemployment peaks at 12.1 percent and real disposable income falls for five consecutive periods -- the 18 companies tested would lose $316.6 billion on soured loans.
“The market will have to wait until the final scenarios will be published next week, but looking at the first details that are coming through it is good to see that the stress scenario seems to be more severe than the ones used in the 2010 and 2011 European stress tests,” said Christian Thun, senior director at Moody’s Analytics.
“On the other hand, comparing it to the two adverse scenarios used by the Federal Reserve in the U.S. during its latest CCAR exercise, one gets the impression that the Americans have used much harsher economic conditions for the euro area,” he said.
Vice President Vitor Constancio said in February that the ECB will use the outcome of its ongoing asset-quality review, which examines the books of 128 euro-area banks, to improve the input data for the stress test, making it more credible.
“The objective is no more doubts about European banks,” he said on Feb. 3. “The balance sheet of European banks will be totally robust and transparent to all investors.”
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