Only Seven European Banks Fail Stress Test, but Was It Too Easy?

Just three months after the Greek debt crisis raised fears about the soundness of the European banking system, only seven of the 91 banks stress-tested to see if they could withstand a financial crisis failed to pass muster. But some analysts say the tests may have been too easy.

The institutions that failed the test -- the ability to maintain at least a 6% Tier 1 capital ratio during a severe recession -- were five Spanish savings banks, one Greek bank, and Hypo Real Estate Holding, a German commercial real estate lender that has already been taken over by the government in Berlin and will be recapitalized.

My take is that the tests were basically not that stressful," says Win Thin, a senior currency analyst at Brown Brothers Harriman in New York. "The numbers seemed to me a little too low and a little too nice."

For example, the Committee of European Banking Supervisors found that the 91 banks had an overall capital shortfall of just $4.5 billion. Banking analysts had been predicting a capital shortfall of between $35 billion and $50 billion.

The stress test scenario asked the question what would happen to the 91 banks, which represent about 65% of the banking assets in Europe, if there was a severe recession in which GDP didn't grow in 2010 and declined 0.4% in 2011. It did not test what would happen if a country like Greece defaults on its debts, which authorities say they won't allow to happen.

No Test For Hypothetical Sovereign Debt Default

"I think if the regulators had built in a more extreme case scenario, where there [were] more sovereign debt defaults, the markets might fear it wasn't just hypothetical, but that somehow, governments had inside information that the markets didn't have about the true risks of those economies," says John Van Reenan, director of the Center for Economic Performance at the London School of Economics. "The problem is that there is now uncertainty over how adequate these stress tests are."

Van Reenan says the European regulators were much more vague than their U.S. counterparts, who conducted stress tests on major American banks last year. "[The European test] is not quite so transparent and that's potentially going to cause the markets to be very jittery," he says.

In addition to not testing whether banks could handle the effects of the default of a country like Greece or Spain, which are currently undergoing financial stress, the European stress test only measured government bonds that are traded, a small percentage compared to the amount on banks' loan books. It's assumed that the bonds on the loan books will be held until maturity, so they weren't considered. But that excluded an estimated 90% of the debts of some banks.

"It seems to me as a little bit of a loophole," says Win. "It's not a full picture -- you're only getting a half a picture. There is a little bit of increased transparency, but I would say its by no means full transparency yet."

Next, Analysts Run Their Own Stress Tests

But the banks were required to disclose their holdings, even if they weren't all considered under the testing paradigm. So bank analysts will likely end up running their own stress tests over the weekend to see which banks are most heavily exposed to the debts of Greece, Spain, Portugal and Ireland, the countries that have been hardest hit by the sovereign debt crisis.

The key test will come on Monday, when the interbank lending market opens. Interbank interest rates have been rising since last summer because of fears about whether lending banks will get paid back by the bank customers.

Currently, 38 of the 91 banks tested rely on government support to meet their capital needs, according to the banking supervisors.

In April, the Greek government was unable to raise money in the financial markets because of fears it might default on its sovereign debts, and was forced to ask the European Union and the International Monetary Fund for a $61 billion bailout package.