Bank stress tests ‘could cause market instability’

Commission to set out banking capital rules.

The European banking industry faces twin challenges over the next few days:  publication of the results of bank ‘stress tests’, and new rules on capital reserves.

Tomorrow (15 July), the European Banking Authority will publish the results of tests into bank vulnerability, which it carried out on 91 of the EU’s biggest banks.

Then on Wednesday (20 July), the European Commission is set to adopt its proposals setting out the amount of capital that banks must retain to protect them against risk, in line with the global Basel III banking rules.
The banking sector is cautious over both moves, and in particular it is apprehensive that the public nature of the stress tests could fuel market uncertainty.

This year’s stress tests are tougher than previous rounds, which were criticised for failing to spot some of the weaknesses in the sector that were later blamed for contributing to the financial crisis.

Olli Rehn, the European commissioner for economic and monetary affairs, said on Tuesday (12 July) that the stress tests were vital because the eurozone’s sovereign-debt crisis was “intertwined with banking fragility”. 

“We cannot solve one without the other,” he said.

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Banks have been tested to ensure that they hold a ‘core’ Tier 1 capital reserve of at least 5%. (Core Tier 1 capital is considered a good measure of financial strength because it does not include subordinated debt, which, in the event of a default, is paid back only after senior debt.) Banks were also tested to check whether they can withstand a downturn in the economy, based on gross domestic product falling by 4%.

Robert Priester, the executive-director in charge of regulatory policy at the European Banking Federation (EBF), is one of the industry figures who believes that this “hypothetical” situation is unrealistic, and who considers that the publication of stress-test results could be damaging.

“The public disclosure of results can be understood in terms of [public] confidence and transparency,” he said. “But at the same time the results will be scrutinised at a superficial level: which bank has passed, which bank has failed, and for the banks that have been given a poor mark, it will be against the background of this hypothetical extreme stress situation. And that bank will have greater difficulty in overcoming its capital deficiency because it has been pinpointed as a bank that has failed.”

On Tuesday, national finance ministers agreed to support all banks that failed the tests. Jan Vincent-Rostowski, the finance minister of Poland, which holds the rotating presidency of the EU’s Council of Ministers, said banks would have to “recapitalise themselves, be recapitalised or restructure”.

Capital rules

The Commission’s long-awaited announcement on how it is to impose Basel III rules on banking capital have also been criticised by the industry.

Banks will be forced to hold higher levels of capital, with even higher levels imposed on banks that pay out bonds and dividends, and on a case-by-case basis for all banks when the economy is in exceptional circumstances.

The review of the capital- requirements directive will see the introduction of a leverage ratio that will limit banks’ ability to fund investments through debt. It will also set liquidity ratios, which will require banks to hold a certain proportion of their funds in the form of cash, or assets that can be easily converted into cash.

Guido Ravoet, the secretary-general of the EBF, said he was concerned in particular about long-term liquidity requirements.

“Even if there is a long transitional period, markets will expect banks to comply already,” he said.