Getting Stressed About European Stress Tests

Global investors will be scrutinizing the results of stress tests for clues to the health of European banks—and they want as much detail as possible. European finance ministers have pledged to oblige when they release results on July 23. "It is clear we want to go to maximum transparency," said Belgian Finance Minister Didier Reynders at a July 13 press conference. Yet European Union finance officials are still debating how much detail from the tests of 91 banks to disclose and how to manage publication of the results.

The European Commission, the EU's executive arm, has warned government officials that failure to publish individual banks' exposure to sovereign debt could damage investor confidence. "There is considerable opposition to the publication of individual exposures to sovereign debt," the Commission said in a confidential letter dated July 9 that was obtained by Bloomberg. "Stepping back" from planned publication of this information "would give the impression that we have something to hide," said the letter, addressed to the EU's Economic & Financial Committee.

"The market is skeptical," Jeroen van den Broek, head of developed-markets credit strategy at ING Groep, told Bloomberg Television. He added that the results "should really highlight the good, the bad, and the ugly banks."

Officials have yet to spell out details of how they would deal with a bank that fails the tests and how additional capital may be provided. Credit Suisse analysts said on July 8 that the "real test" will be the readiness of governments to respond. Speaking at the press conference with Reynders, EU Economics and Monetary Affairs Commissioner Olli Rehn said that banks must raise money themselves before seeking state support. He also said he favors "financial backstops" that would start with national funds. States could then turn to the European Financial Stability Facility set up in May to aid indebted nations, although he does not believe they will need to.

Another issue: Stress tests may not be rigorous enough or assume large enough potential losses, says James Nixon, co-chief European economist at Société Générale in London. Regulators have told lenders the assessments may assume a loss of about 17 percent on Greek government debt, 3 percent on Spanish bonds, and none on German debt, said two people briefed on the matter who declined to be identified.

"The haircut for Greece looks a little shallow," Nixon says, "and the particular concern is that if there is a sovereign default in Europe, it will be significantly bigger." Banks globally could lose as much as $900 billion in a worst-case scenario where Greece, Ireland, Italy, Portugal, and Spain all have to restructure their debt, Nomura Holdings estimates. Dutch Finance Minister Jan Kees de Jager has said the stress tests will not include possible sovereign defaults, which he doesn't expect to happen.

In one positive development, Greece sold $2.1 billion of Treasury bills on July 13 at a yield of 4.65 percent. That's below the 5 percent the European Union charged when it lent money to Greece in May to rescue it from default. "It's an encouraging sign that Greece can finance its short-term requirement," says Michiel de Bruin, who oversees $32 billion of European government debt at F&C Asset Management in Amsterdam. "It's a step in the right direction. But it's perhaps too early to say the situation has turned in the euro zone."

The bottom line: Investors want to see details of the stress tests—and to learn how banks that fail them will raise the extra capital they need.

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