Europe Banks Face Toughest Simulated Slump in Stress Test

European Union banks will be ranked on how well they can withstand a 21.2 percent slump in home values, coupled with a surge in unemployment and plummeting economic growth, as part of the bleakest scenario in the most severe EU stress test to date.

The exams will also simulate a 19.2 percent drop in stock prices over three years, as well as a 14.7 percent fall in commercial real-estate prices across the 28-nation EU, the European Banking Authority said in a statement. The Hungarian forint and Polish zloty will lose a quarter of their value under the so-called adverse scenario to express losses on mortgage lending in central and eastern Europe.

As the European Central Bank prepares to take over supervision of about 130 euro-area lenders from BNP Paribas SA to National Bank of Greece SA starting in November, regulators have sought to compile the toughest stress tests in a bid to repair credibility damaged by assessments in 2010 and 2011 that didn’t uncover weaknesses at banks that later failed. The tests are part of a so-called comprehensive assessment of banks that also includes an asset-quality review.

“The exercise’s full transparency will be key to its credibility,” Andrea Enria, chairman of the EBA, said in the statement. The stress tests will form a “robust and effective tool for supervisors to address remaining vulnerabilities in the EU.” The EBA tests will cover 124 banks across the EU.

U.K. Banks

The Bank of England announced today that it will, in parallel, impose its own tests on British banks, in a bid to capture “particular vulnerabilities facing the U.K. banking system.” Lenders will take part in its tests in addition to the EU exams.

Under the U.K. plans, lenders such as HSBC Holdings Plc, Barclays Plc and Royal Bank of Scotland Group Plc, will face a stress scenario that’s tougher in some respects than the EBA approach.

While the capital pass mark will be lower than for the EU exams, the definition of what can count as capital will be stricter.

The EU tests will simulate output that misses the European Commission’s growth forecasts in 2014 through 2016 by a cumulative 7 percentage points with a corresponding rise in unemployment to 13 percent and stagnant consumer prices.

The scenarios address criticisms of the 2011 exercise, which modeled the effect of a fall in output of 0.4 percent that year, followed by a year of static growth in 2012. The adverse scenarios then were overtaken by reality a year later. Economic activity fell 0.4 percent in 2012, according to data compiled by Eurostat.

Tough Test

The EBA plans amount to “a tough stress test,” said Jesper Berg, a member of Nykredit Bank’s executive board.

“If you want to be critical, you could argue that the distribution of stress relative to what is likely is tougher on the countries that have fared well during the crisis than for those who were in the ropes,” Berg said. “However, most banks in northern Europe are extremely well capitalized and should pass with ease.”

The EBA exercise, which will cover more than half of each EU member state’s banking industry, is scheduled to begin about the end of May, while results will be published at the end of October.

It will form the last part of ECB President Mario Draghi’s effort to stamp out lingering doubts about the health of the region’s lenders before his institution becomes the euro-area’s prime bank supervisor.

Capital Shortfalls

The ECB said today that banks will have six to nine months to address capital shortfalls revealed by the comprehensive assessment.

Lenders “should start to consider what private sources of capital could be raised as a result of this exercise and plan accordingly,” ECB Vice President Vitor Constancio said in a statement.

It’s “possible that the level of stress within these tests is insufficient to fully restore the credibility that the ECB is seeking to build,” Folkert Jan van der Veer, a senior analyst at asset manager Cairn Capital, said in an e-mail. “Even though the ultimate stress test scenarios may lack severity, there is already clear evidence that the stress tests are bearing fruit, with banks actively building capital levels and provisions.”

The adverse scenario is designed to undershoot EU growth and unemployment forecasts, which make up the so-called baseline scenario, to simulate financial stress and help banks identify where they could be most vulnerable.

Baseline Scenario

As a pass-mark for the baseline scenario banks have to be able to maintain a capital-to-risk-weighted-assets ratio of 8 percent. In the adverse scenario, where lenders are allowed to run down capital buffers, the ratio is 5.5 percent.

The 5.5 percent hurdle is “very low in our view,” Van der Veer said. “Investors should question whether a bank falling short of the hurdle rate would have any options left to raise capital independently.”

Although EU banks haven’t had to face a public bloc-wide stress test in three years, the EBA told them in 2012 to hold on to more than 200 billion euros ($277 billion) in capital raised in response to concerns about the quality of their European sovereign bond portfolios and how deeply they were hit by the economic crises in countries such as Greece and Spain.

Sovereign bonds won’t escape scrutiny. The adverse scenario tests for a government debt yield hike of about 150 basis points over 2014 and around 110 basis points in 2015 and 2016, averaged out across the EU.

The European Systemic Risk Board, a group comprised of EU central bankers, devised an adverse scenario that “reflects the systemic risks that are currently assessed as representing the most pertinent threats to the stability of the EU banking sector,” the EBA said in the statement.

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