Rising Stress Over European Bank Stress Tests

Ever since the crisis over Greek government debt erupted last month, there have been increasing concerns that European banks that own those bonds could be facing huge losses. The Obama Administration has even pressed European authorities to release the results of so-called stress tests on the major European banks as they are completed to reassure the markets that the banks are still sound.

At least some of those concerns were allayed Friday when Moody's (MCO) published the results of its own stress tests on the 30 largest European banks, saying that banks holding sovereign debt were in relatively good shape.

"We believe that Europe's largest banks will be able to absorb losses stemming from their exposure to Greece, Portugal, Ireland and Spain without requiring capital increases even under what we qualify as a severe stress scenario," the Moody's report said. "The banks that we examined as part of our analysis have adequate capital cushions to absorb losses even under harsh economic scenarios."

Moody's said most bank regulatory capital levels -- the money they keep in reserve to use in a crisis -- are "well above 9%" and are typically close to 10%. It said European authorities would probably force the banks to raise more capital if the regulatory capital ratio fell below 7%.

One interesting result of the anonymous survey -- Moody's didn't identify which banks participated -- was that apart from Greece, bank exposure was higher to private debt than government debt in Portugal, Ireland and Spain. Private debt is easier to finance than government debt, because the financial markets may simply stop buying government bonds.

Questionable Assumptions

The Moody's report came after the European Central Bank reported last week that banks in the 16-nation eurozone face $110 billion in potential write-downs this year and an additional $128 billion in 2011.

While the Moody's report was likely to lift financial stocks in Europe, the assessment has come under criticism for adopting too rosy a scenario in the event that countries like Greece, Portugal, Ireland and Spain can't pay their debts. For example, it assumed bonds would fall only 20% if there were a meltdown.

"It's just a completely unrealistic view of the world," says Gary Jenkins, head of fixed income research at Evolution Securities in London. Jenkins says that if all four countries defaulted at the same time, bond prices would go "much, much lower" than a 20% decline.

He also suggests that if there were a major sovereign debt default in Europe, no investors would lend banks money. So, he says, the banks' capital ratios would be irrelevant. "Unless the central banks were prepared to continue to fund the entire banking sector, all of the banks would go bust within 48 hours," he said.

Growing Pressure

There has been growing pressure in Europe to publish the stress test results once they are complete. The U.S. conducted stress test on banks last year and released the results, which helped to stabilize the markets for financial shares.

Jean-Claude Trichet, the president of the ECB, expressed frustration Thursday at the reluctance of Spain and Germany to publish the results of their stress tests on banks. Regulators should "do all that is necessary to improve the sentiment of the market," Trichet said.

Mario Draghi, the head of Italy's central bank, said Europe should follow the American example. "It clears the air and basically puts banks in a condition they would be able to raise capital," Draghi said. "I think we should aim at doing the same."

Treasury Secretary Tim Geithner also urged the Europeans to release the results of the tests, which they didn't do last year. "Markets work better when they're not operating in the dark," Geithner told a news conference in South Korea.

Jenkins says he doubts whether European authorities will be receptive to conducting such tests at this time of crisis. "I have a feeling that in Europe they are trying to avoid that," Jenkins says. "Because the only time you really ant to undertake a stress test of your banking system is when you already know the answer."

Even though Moody's gave Europe's largest banks essentially a clean bill of health, there are increasing signs of problems in the system. For example, the London interbank offering rate – the interest rate banks charge to lend to each other in Europe – has doubled in the last few months. Bank commercial paper issuance has fallen $15 billion in the last week – a sign they are having troubles rolling over their debts.