Europe released the Results of Stress Test on Friday


The results of the 2010 EU-Wide Stress Testing Exercise have been released on Friday, 23rd July, 2010. 7 of the 91 banks tested has failed the test, with a necessity of global EUR 3.5 billion extra capital in case of continuing crisis until end of 2011. In case of sovereign shock, the aggregate lost to the whole testing could be of EUR 67.2 billion.
According to the Committee of European Banking Supervisors and national authorities across the European Union, the seven banks that have failed the test are Banca Civica, Unim, Espiga, Diada and Cajasur from Spain, ATEBAN from Greece and German HYPO. French, Portuguese, Italian, Finnish, Swedish and Belgium top banks all passed.
The tests were intended to reassure investors and help ease pressure in bank funding markets as the global financial crisis -- and in particular worries about sovereign debt in many European countries -- undermined confidence in the banking system.
Officials used two sets of macroeconomic scenarios -- benchmark and adverse, in order to stress test the credit risk and simulate profit and losses.
Within the adverse scenario, the exercise also envisages a "sovereign risk shock," reflecting adverse conditions in financial markets.
The benchmark macroeconomic scenario assumes a mild recovery from the severe downturn of 2008-2009, whereas the adverse scenario assumes a "double-dip" recession.
For example, Germany's biggest bank, Deutsche Bank, achieved a Tier 1 capital ratio under the adverse scenario of 10.3%, while under the additional sovereign risk scenario its Tier 1 ratio declined to 9.7%.
The decision to model a sharp drop in the price of sovereign debt has been criticized, but to assume that no country would actually default, which means banks only had to record losses on sovereign bonds they held for trading purposes.
The assumptions taken in the tests were tougher than those used in the U.S. stress tests last year.
CEBS also defended the decision not to assume any sovereign default, saying the €750 billion support package put together by the EU and the International Monetary Fund effectively ruled out a default.
The EU governments will not allow banks to actually fail in the market, thus it is the sovereign bond market that is key in the short term, because there is not anyone who can bail out the governments.
Of the 91 financial institutions tested by the Committee of European Banking Supervisors (CEBS) in the European Union, nearly one third were Spanish. Particular attention was focused on the country's savings banks, known as cajas, which have been hard hit by bad bets on the collapsed construction and property market.
Germany's Hypo Real Estate and Greece's ATE Bank were the only non-Spanish banks that failed the test, which was given to 91 banks in the European Union.
While the big banks largely held by U.S. investors, including Banco Santander and BBVA sailed through the stress tests as expected, four savings banks will require €1.84 billion in additional funding to keep Tier 1 ratios above 6% in the worst-case scenario. The fifth failed bank, Cajasur, which made the headlines last May, has already been taken over, but was counted among those that failed.
Investors seem to be worried that the stress tests still excludes the possibility of a sovereign default of a sovereign default as the data is based mostly on trading portfolios information when much of sovereign debt is held outside those portfolios.
With a disappointing market reaction, is clear the fact that the stress tests could be underestimating possible losses by excluding the risk of a sovereign default and could undermine their credibility as indicators of the financial health of European banks. 
A comparison with the U.S. stress test from last year shows major differences, but suggests that Europe's effort may have been no softer on its big banks.

One controversial move was that European authorities included a possible sovereign debt shock, but only projected losses from such an event on banks' trading books -- not on the assets they hold to maturity.

It is known that the biggest risk to solvency/liquidity that the EU banks face is sovereign risk haircuts and the fact that the stress is only driven into the trading book (which is perhaps 1% of total assets) means little capital will be needed.

Still, the EU test also included potential knock-on effects from a jump in government bond yields, including a significant increase in interest rates for other borrowers like corporations. The U.S. bank stress test didn't consider any sort of sovereign crisis.

Other differences and similarities are listed below.

What banks were tested and where?

In the U.S., 19 of the largest bank holding companies were tested. Three supervisory authorities were involved in one legal jurisdiction.

In Europe, 91 banks were tested, with 27 supervisory authorities involved in 27 jurisdictions.

When was the test done?

The U.S. stress test was done in February 2009 and the results came out in May 2009.

The European test was conducted in recent months and the results were released on Friday. With more than a year having passed, European banks and governments have had longer to respond to the financial crisis. From October 2008 to the end of May this year, EU governments injected 236 billion euros into European banks, helping them boost capital ratios. Indeed, 38 of the 91 banks in the European stress test currently rely on government support.

General approach

U.S. authorities measured how much of an additional capital buffer each institution might need to ensure that it would have enough capital if the economy weakened more than expected.

The EU took a similar approach, but with a twist that included possible losses from another sovereign debt crisis like the one triggered earlier this year by Greece's problems.

What targets were used?

The U.S. stress test focused not only on the amount of capital but also on the composition of capital held by the 19 banks. It assessed the Tier 1 risk-based capital ratio and the proportion of Tier 1 capital that was common equity. Tier 1 Common capital measures common equity, which is the first element of the capital structure to absorb losses, offering protection to more senior parts of the capital structure and lowering the risk of insolvency. The Tier 1 Capital ratio had to be 6%, while the Tier 1 Common ratio had to be 4%.

Europe just focused on the Tier 1 Capital ratio, also having a 6% target. It didn't use a Tier 1 Common benchmark because there's no single definition of what that is in the region, so apples-to-apples comparisons would have been tricky.

Economic scenarios

The U.S. used the following adverse scenario: Real GDP would shrink 3.3% in 2009 and grow 0.5% in 2010; the unemployment rate would hit 8.9% in 2009 and 10.3% in 2010; and house prices would slump 22% in 2009 and fall 7% in 2010.

In Europe, authorities projected that EU real GDP would be on average 3 percentage points lower than currently expected in 2010 and 2011. That implies a recession in those years. Along with that, "significant" increases in interest rates were modeled in 2010 and 2011. A sovereign debt "shock" was also modeled, in which five-year government bond yields jump to 4.6% on average from 2.69% at the end of 2009. Knock-on effects from this were also taken into account -- for instance the possibility that if government yields jump, interest rates for other types of borrowers would rise too, making losses on assets like corporate bonds more likely for banks.

What assets were stressed?

In the U.S. stress test, generally all the banks' assets were evaluated under the adverse economic scenario.

European authorities tested all the assets of the banks under its adverse economic scenario. But the sovereign shock only applied to banks' shorter-term trading books, not the assets they hold to maturity. However, EU authorities noted that massive bailout programs they put in place after Greece's debt crisis have made it highly unlikely that a European country would default. That means banks might have to mark down the value of government bonds in their trading books in the short term. But by the time the debt matures and is paid off, values will have returned to their original levels.

General results

U.S. authorities projected that if the economy were to follow the more adverse scenario, losses at the 19 banks during 2009 and 2010 could be $600 billion. The bulk of the estimated losses -- roughly $455 billion -- would come from losses on the banks' accrual loan portfolios, particularly from residential mortgages and other consumer loans. Estimated losses from trading-related exposures and securities held in investment portfolios totaled $135 billion. U.S. banks needed to raise $75 billion in capital. Most of the shortfall was in Tier 1 Common capital, with virtually no shortfall in Tier 1 capital.

The EU's adverse economic scenario produced projected losses of 473 billion euros in 2010 and 2011 for the 91 banks in the test. All that was from impaired loans on the banks' balance sheets. A sovereign debt shock would trigger another 39 billion euros of losses in banks' trading books, while knock-on effects from such a crisis could add another 28 billion euros in losses over 2010 and 2011. That produced a total of 566 billion euros in losses.

Which banks failed the tests?

In the U.S., 10 out of the 19 banks failed the test and nine passed. Bank of America, Citigroup,Wells Fargo, Fifth Third, GMAC, KeyCorp, Morgan Stanley, PNC Financial Regions Financial, SunTrust all needed to raise capital.

In Europe, seven banks failed in three countries. Germany's Hypo Real Estate and Greece's ATEBank couldn't keep a Tier 1 Capital ratio of more than 6% under the test. Five banks in Spain, including recently merged Cajasur, also didn't make the grade.