European Bank Stress Tests Said to Describe Three Scenarios

By Meera Louis and Jann Bettinga - Jul 20, 2010


European regulators plan to detail three scenarios when they publish the results of their stress tests on the region’s banks this week, according to a document by the Committee of European Banking Supervisors.

Banks will publish their estimated Tier 1 capital ratios under a benchmark for 2011, an adverse scenario and a third test that includes “sovereign shock,” according to a template prepared by CEBS for the banks and obtained by Bloomberg News.

In the last scenario, banks will publish their estimated losses on sovereign debt they hold in their trading book as well as “additional impairment losses on the banking book” that they may suffer after a sovereign debt crisis, according to the document that was dated July 15.

Under accounting rules, banks have to adjust the value of sovereign bonds held in the trading book according to changes in market prices, said Konrad Becker, a financial analyst at Merck Finck & Co. in Munich. For government debt held in the banking book, lenders must write down their value only if there is serious doubt about a state’s ability to repay its debt in full or make interest payments, he said.

The sovereign-shock scenario doesn’t assume a European nation will default, said a person with knowledge of the matter, who spoke on the condition of anonymity because the information is private. Instead, it will assume that rising government-bond yields will push up borrowing costs, spurring defaults in the private sector that would lead to losses in lenders’ banking books, said the person.

EU Stress Tests

CEBS coordinates national banking authorities and makes policy recommendations to the European Union on regulation. Spokeswoman Efstathia Bouli declined to comment.

EU regulators are examining the strength of 91 banks to determine if they can survive potential losses from both a recession and a decline in the value of their government bond holdings. They are using the tests to reassure investors about the health of financial institutions from Germany’s WestLB AG and Bayerische Landesbank to Spanish savings banks as the debt crisis pummels the bonds of Greece, Spain and Portugal.

The banks may publish how much they will need to raise in capital if their Tier 1 ratio, a key measure of financial strength, falls below 6 percent under the sovereign scenario, the draft shows. Lenders will also provide estimated loss rates for their corporate and retail holdings for the adverse cases, according to the template.