Stress Test Result Appeared to be Stronger than Expected. Stringency in Question

The CEBS's stress test result was out yesterday. 7 out of 91 European banks failed the test - failed to exceed the 6% Tier 1 capital ratio under the most severe scenario. These banks are Diada (Spain), Espiga (Spain), Unnim (Spain), Banca Civica (Spain), Cajasur (Spain), ATEBank (Greece) and Hypo Real Estate (Germany). According to the CEBS, the estimated aggregate shortfall is 3.5B euro. In a joint statement, the CEBS, ECB, and European commission said that, 'where the results of the exercise indicate that individual banks require additional capital, these banks should take the necessary steps to reinforce their capital positions through private-sector means and by resorting, if necessary, to facilities set up by Member State governments, in full compliance with EU state-aid rules'.

In total, aggregate impairment and trading losses under the adverse scenario and additional sovereign shock would amount to 566B euro over the years 2010-2010.

The aggregate Tier 1 ratio, used as a common measure of banks' resilience to shocks, under the adverse scenario would decrease from 10.3% in 2009 to 9.2% by the end of 2011 (compared to the regulatory minimum of 4% and to the threshold of 6% set up for this exercise). The aggregate results depend partly on the continued reliance on government support for currently 38 institutions in the exercise.

Apparently, the result is positive as 92% of the banks examined passed the test and the aggregate shortfalls of 3.5B euro was less that many analysts anticipated. However, the market has different opinions on the assumptions used in the test. Many argued that the test was not rigorous enough and the result failed to assure investors that the banking system is stable. Moreover, there was no test for a sovereign default but regulators said it's not necessary as every possible measure has been used to avoid a default from happening.

Yet, regulators believe the test would help foster confidence. The ECB said the test 'represents an important step forward in supporting the stability of the EU and euro-area banking sectors' and the criteria were 'substantially adverse in macroeconomic and financial terms'.

Mario Draghi, Financial Stability Board Chairman, said the test ' is an important contribution to bolstering confidence in the European banking system and strengthening the resilience and robustness of the global financial system' and 'the results provide additional clarity and transparency on the strength of the European banking sector'.