Everyone experiences a little bit of stress from time to time, and European banks are no different.
Last month, members of the European Council agreed that a new set of stress tests would be applied to 91 publically traded banks across the Continent aimed at preventing another crisis. What exactly is this “stress test” and how does it work?
Europe’s test is actually modeled after that used by the U.S. Federal Reserve in the spring of 2009. U.S. bank regulators conducted two tests on the 19 largest U.S. banks to see how they would hold up under a baseline economic scenario and then an adverse scenario. Those that fell short were required to raise more capital.
When the results came out in May, 10 of the banks were told to raise a total of $75 billion in common equity, which they all did. This included Bank of America raising $33 billion, Citigroup raising $5.5 billion and Wells Fargo raising $13.7 billion. As a result, analysts argue that public and investor confidence in the banking industry was restored.
“They’re probably thinking: ‘It worked for the Americans, so let’s do it for our banks.’ Hopefully, it will work and provide useful information,” said Thomas Mondschean, professor of economics at DePaul University.
These tests, conducted by the Committee for European Banking Supervisors, or CEBS, will check if banks can raise enough capital assuming gross domestic product falls 3 percent below current forecasts in each of the next two years. This amounts to a 2 percent decline in GDP for 2010 and a 1.3 percent decline in 2011 across the European Union.
The CEBS will determine whether banks meet a critical threshold, or minimum Tier 1 capital requirement, of 6 percent. Not surprisingly many of the 91 banks being tested are concentrated in the most troubled economies of Spain, Germany, Greece and Italy.
“The heart of the crisis is that banks didn’t have enough capital. The largest banks that were too big to fail have to have more capital,” Mondschean said. “Will there be winners and losers? Of course. Some banks are undercapitalized and will have to shore up their balance sheet.”
Although many are unsure about how each bank will fare, legislators are convinced the tests are one step closer to preventing any future problems.
“The data up to May confirm that the size of banks’ overall balance sheets has increased since the turn of the year,” said Jean-Claude Trichet, president of the European Central Bank, at a press conference in Frankfurt Thursday. “The challenge remains for banks to expand the availability of credit to the non-financial sector when demand picks up”.
Results of the stress test will be announced July 23.