European Banks Face 5.5% Capital Hurdle in EBA Stress Test

The largest banks in Europe will have to show their capital won’t dip below 5.5 percent of their assets in an economic crisis, the European Union’s top banking regulator said.

The exercise, which will examine a sample of 124 banks that cover more than half of each EU member state’s banking industry, is scheduled to begin around the end of May, the European Banking Authority said in a statement today. Results will be published at the end of October.

The tests will be the first in Europe since the EBA told banks in December 2011 to raise 114.7 billion euros ($155 billion) in fresh capital to respond to the area’s sovereign-debt crisis. The EBA’s so-called core-equity Tier 1 requirement is less than the 6 percent proposed by the European Central Bank, according to two euro-area officials with knowledge of the discussions earlier this month.

It’s not clear “if the EU-wide methodology of the EBA for its stress test is identical to that of the ECB’s stress test,” Michael Kemmer, managing director of the Association of German Banks, said in an e-mail.

“In the future, it would be important for the EBA and the ECB to agree on their communication with each other in advance,” Kemmer said. “Conflicts between European authorities shouldn’t be carried on to the detriment of the banks.”

Local Regulators

Local regulators may create “additional and specific macroeconomic sensitivities and market-risk shocks in order to incorporate country-specific features as deemed necessary,” the EBA said. The banks will have to submit those results to the authority.

Deutsche Bank AG, Banco Santander SA, BNP Paribas, Barclays Plc and Royal Bank of Scotland Group Plc are among banks that will face exams, the regulator said. The lenders will be tested on resilience to credit, market and sovereign risk, securitization and cost of funding. Both trading and banking book assets will be tested, according to the authority.

The EBA methodology also forms the basis for the ECB’s own stress test, the third part of its comprehensive assessment designed to pave the way for it to take over supervision duties from domestic regulators in the euro area in November.

U.K. stress tests “will be run alongside the EBA’s EU-wide exercise,” the Bank of England said in an e-mailed statement. Details “are being discussed at the Financial Policy Committee and the Prudential Regulation Authority board in the coming months,” it said.

‘Adverse Scenario’

ECB President Mario Draghi has said he’s determined to convince investors that the health check of institutions is thorough and credible. The EBA set a pass mark of 5 percent in 2011, when models of an economic “adverse scenario” failed to reveal shortcomings at banks that later collapsed.

The second part of the ECB’s comprehensive assessment of bank balance sheets, the Asset Quality Review, evaluates lenders’ health under current economic and financial conditions, and sets a minimum capital requirement of 8 percent. The test will cover a three-year period from 2014 to 2016, and will measure banks’ resilience to losses.

‘Sustained Focus’

The EBA’s list of 124 banks in the EU overlaps with the 128 lenders being assessed by the ECB in the 18-member euro-area. According to the EBA’s guidelines, the ECB may decide to set stricter requirements for the stress test and include more lenders than mentioned by the EBA if it sees fit.

Banks taking part in the stress test won’t be able to include potential asset sales in their calculations of how they would fare during the so-called adverse scenarios.

While that approach “will on the face of it enhance the comparability of results, it has the effect of disadvantaging banks that could take management action more quickly,” David Strachan, head of regulatory strategy at Deloitte LLP, said in an e-mail. “That will need to be borne in mind when judging the implications of the results.”

The EBA, whose members include supervisors from the euro region and other European Union countries, was set up in 2011 to harmonize banking rules. The ECB will become a full member of the EBA when it starts supervising euro-area lenders.

“This exercise aims at ensuring consistency and comparability of the outcomes across all banks based on a common methodology, scenarios and accompanied by a consistent disclosure exercise,” the EBA said.

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