Market cynicism greets European Union bank stress test results

"There is so much scepticism in the market with respect to the outcome,"
wrote Mr Peters.

The methodology for the stress test was reasonably simple. Banks' performance
was modelled against three theoretical scenarios.

Firstly the benchmark case, which looked at a bank's financial strength over
the next two years assuming current growth trends were maintained.

This was followed by two "adverse scenarios", the first involving
two years of worsening economic conditions, and the second based on a "sovereign
shock" whereby European government bond values would fall to rock
bottom levels.

What this meant in effect was that a varying discount was applied to the value
of European government debt, with the UK bond market down just over 10pc in
the most stressed conditions, while Greek paper was given a 23pc haircut.

The tests were conducted under the guidance of the Committee of European
Banking Supervisors (CEBS) by domestic regulators, with the Financial
Services Authority overseeing the process in the UK.

All the tests relied on data supplied by the banks and verified by their local
regulator, leading to suggestions that the implementation of the scenarios
depended to some degree on the local authorities.

It is also widely recognised that the tests in some cases are less onerous not
just than the ones already conducted by some regulators, but also than the
banks' internal worst-case forecasts.

One common thread between all the regulators is their avoidance of the word "fail",
instead opting to refer to a "capital shortfall" – in other words
the difference between a bank's post-stress test capital and the 6pc minimum
Tier 1 capital ratio required to pass.

So what happens to those banks deemed to have a "capital shortfall"?

Before Monday it seems a good bet that some of the weakest will have been
forced into stronger hands by regulators keen to see the industry heal
itself. Those that aren't rescued by takeover will then be left in the
awkward position of having to raise equity. Investors would be the natural
first port of call but institutions are unlikely to welcome banking lepers
with open arms.

If the markets reject them, the banks will look to their governments for
taxpayer assistance. More part-nationalisations, along the lines of Royal
Bank of Scotland, seem inevitable.

However, the crisis may not stop there. It is conceivable that some European
governments will not be able to recapitalise their troubled lenders. In
Greece, for example, €10bn (£8.4bn) of the €110bn aid package Europe
delivered earlier this year has been ringfenced for the banks.

Many European nations don't have the funds available to bail out their
lenders. Spain earlier this year drew up plans for a €100bn bank rescue
fund, but said it would raise the money in the markets as and when it needed
it. Only €12bn has been raised so far. To bail out the banks, the Spanish
government would have to raise sovereign debt – putting it at the mercy of
the markets.

Spain is not alone. Although it is unlikely that Spain would be unable to fund
its recapitalisation needs, other smaller nations may not be treated so
kindly. That's where the European Financial Stability Facility (EFSF) comes
in. The EFSF, formed under the €750bn European and International Monetary
Fund bail-out plan struck in May, can issue up to €440bn to stricken
eurozone countries. If governments are rejected by the markets, the EFSF is
their last port of call.

However, the funds will not come cheap. Applications for the money will only
be approved if the governments can persuade the IMF and Brussels that they
will be able to repay the loan, which is likely to mean further austerity.
On top of which, the borrowing country will have to pay a punitive rate.
Once Brussels and the IMF are satisfied, the EFSF will issue bonds backed by
all European nations to raise the sum required.

It may be uncomfortable, but Europe's overindebted banks will be fixed.

Markets appeared to take comfort from that thought, though with the weekend to
look over the results in detail, Monday's trading session could be busy as
investors look to reposition themselves.

The clearest sign that the tests have set the European banking industry on the
path to recovery will be seen in interbank lending and the capital markets –
if these do not improve then Europe will have to think again.

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