What is... | December 21, 2010

What is bank “stress testing”?

What exactly are bank stress tests and why do they matter? Take a look at our answers to five important questions.

The results of so-called “stress tests” on European banks were published on Friday on the Committee of European Banking Supervisors website.

What are these stress tests and who was tested?
The stress tests simulate how European Union (EU) banks would cope if economic conditions worsened, including the possible effects of a worsening of the debt crisis affecting countries like Greece. The tests aim to identify which banks need to raise capital to ensure they are strong enough to withstand a worsening recession. In total, 91 banks in 20 countries (which make up 65% of the European banking sector) were tested. In each EU state, the sample included enough banks to cover at least 50% of the national banking sector. Similar tests were done in the United States last year.

Why were the tests done?
The stress tests were conducted to try to reassure financial markets about the health of the EU's banking system. The aim was to restore investor confidence by pinpointing any weak spots and forcing some banks to raise cash. General doubts about European banks' ability to clean up their balance sheets have limited their ability to raise funding and made some dependent on liquidity supplied by the European Central Bank (ECB) since large investment bank Lehman Brothers collapsed in 2008.

How do the tests work?
The stress tests were carried out by national supervisors and coordinated by the Committee of European Banking Supervisors (CEBS), a London-based umbrella group for financial supervisors. Each bank was tested on its ability to withstand losses in the event that the economic growth rate would be three percentage points below the European Commission’s forecasts for the next two years.
The tests also looked at how banks would fare if government bond prices were even lower than the depressed levels they hit during the Greek debt crisis in May. Banks were examined to see how their so-called Tier 1 capital, a key measure of financial strength, bore up under the test scenario. The ECB wanted to see if the ratio of this capital to risk-weighted assets stayed above a minimum benchmark of 6%.

What will the test outcomes mean for European banks?
The US tests last year found 10 banks that were short of capital. Those banks swiftly announced fund-raising plans of their own. For example, Bank of America (which had the largest shortfall at US$33.9 billion) said it would take steps that included issuing US$17 billion in common stock and selling some assets. European banks that “fail” the tests may raise their own funds, tap national funds set up in countries such as Germany and Spain, or turn to the €60 billion EU fund. If that is not enough, they could call on the European Financial Stability Facility, detailed in an earlier eZonomics story
A summary of the 91 bank-by-bank results by country can be downloaded from the CEBS website here.

What will the results mean for the markets?
It is not completely clear yet what the long term response to the European bank stress tests will be. Markets were not reassured last year by limited stress tests of a small number of European banks (the results of which were not released for individual institutions).
However, this round of EU tests is seen by some as being closer in scope, rigor and transparency to the US stress tests done during the global crisis. The US tests succeeded to some degree in easing investor worries. Now the test results are out, investors will likely want to see national governments act quickly to resolve any problems that have been uncovered, if banks are unable to raise enough capital from the markets by themselves. 
As in the US last year, the results of these European tests may help soothe fears over the health of the financial industry and so open the door for private capital to return to the banking sector.


eZonomics team
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