Europe's banks need to keep their core capital above 5 per cent in a test imagining a two-year recession, in order to pass the regional exam aimed at reassuring taxpayers and repairing the sector's image.
The European Banking Authority (EBA) today named 90 banks which must undergo the "stress test". It will determine how many need to raise capital, sell assets or shrink their loan book to make them strong enough to withstand economic headwinds.
The EBA, keen to be seen as tough after last year's health check flopped, will use a definition of capital that is more stringent than last year. The 5 per cent pass mark for core Tier 1 capital is comparable to the standard set for US banks under their private health check, the EBA said.
The US results were released to the banks last month but not made public. Banks that came through strongly were allowed to bump up dividends or buy back shares. In contrast, European banks are being encouraged to keep conserving capital.
Jean-Claude Trichet, president of the European Central Bank, said it was up to national governments "to stand ready to do whatever is necessary" to fix problems shown up by the test.
Europe's regulator, running the stress tests for a third time since the financial crisis unfolded, said it will exclude much of a hybrid capital instrument used by many Germany state-owned banks, seen as one of the most controversial issues.
The results will be released in June.
The exercise aims to draw a line under the region's banking problems and is already having an impact.
Banks are bolstering capital ahead of the test. Even though few banks are expected to fail, being close to failing could prompt weak banks to raise capital. Plans unveiled by the end of this month can be included in the heath check.
Germany's Commerzbank AG, along with Italy's Intesa Sanpaolo and Banca Monte dei Paschi di Siena SpA, this week unveiled plans to increase their capital cushions.
Banks that fail the test, or some that only narrowly pass, are expected to work with their national regulators to fix the problem.
The EBA wants countries to have a backstop plan to provide capital, but banks are expected to have until the end of this year to discuss raising cash privately, selling assets or deleveraging to bolster their capital position.
Europe's listed banks are expected to raise at least 40 billion euros this year and Spain's private savings banks, or cajas, will raise a similar amount, according to a majority of investors polled at a top conference last month.
Fewer than 10 banks are expected to fail the EBA stress test according to more than four-fifths of the 800 investors polled by investment bank Morgan Stanley.
However, banks seen in the "near pass" region are likely to come under pressure to raise cash or see their shares discounted in comparison to rivals who have built capital up to robust levels.
Portugal's economic troubles have raised fears the capital level of its banks will be eroded by low economic growth and rising bad debts, and need bolstering.
The EBA said it has set the most consistent definition of core Tier 1 capital possible - given it varies among countries - that mainly comprises common equity and retained earnings.
To qualify, capital instruments have to be simple, issued by the bank and able to absorb losses as a going concern. It strips out hybrid instruments, including preference shares, but includes existing government support measures as they would "absorb losses and shelter banks in case of difficulties".
Some of German banks' "silent participations" will be allowed, but some will not. Silent participations are a hybrid debt-equity instrument used widely by local regulators, but which critics say may not absorb losses under stress.
The "stress" situation includes economic slowdown, rising unemployment, tumbling property prices and a drop in stock markets.
But like last year there will be no stress testing of the sovereign debt held in banking books, rather than banks' short-term trading book, as governments do not want to spook markets by contemplating a sovereign default.
Banks must hold a minimum of 7 per cent core Tier 1 capital under new global capital rules known as Basel III, from January 2013, though countries such as Britain and Switzerland have already put the bar at 10 per cent or more.
Reuters
