Most banks pass EU's stress tests but financial system worries persist

ROME and TORONTO -- The long-awaited results of stress tests on Europe's major banks haven't uncovered any "skeletons in the closet," but they have failed to put to rest nagging concerns over whether its financial sector can withstand future shocks.

Just seven of 91 banks in the European Union flunked the closely watched test, which gauged their core capital, the effect another recession might have on their health and the potential deterioration of government bonds in their trading accounts. The 91 banks account for 65 per cent of the European market, measured by assets.

European authorities on Friday trumpeted the test results as proof that the financial system is resilient enough to weather any storms on the horizon, including sovereign debt losses.

They plainly hoped the tests would bolster flagging confidence not only among investors but other banks as well, much as similar U.S. tests did last year.

But some observers questioned the credibility of the European examinations, and whether the positive scores would ease the fears of investors worried about Europe's deepening sovereign debt crisis and the long-term health of its financial sector.

If Europe can't calm investor nerves, financing costs are going to rise, bank balance sheets will be under pressure and economic recovery will be hampered.

"Many market participants won't be satisfied with the difficulty of the stress scenarios," said Benjamin Reitzes, an economist with BMO Nesbitt Burns.

"The results bring some relief, but won't be enough to eliminate worries about Europe's banking system," he said in a note to clients.

One concern is that the tests excluded government bonds being held on the banks' books, an omission that reduces potential losses from future sovereign debt restructurings. Also, more than 70 banks that depend on the European Central Bank for their funding were not tested at all.

"What can be said is that today's stress test release does not appear to have uncovered any 'skeletons in the closet,'" Chris Turner, head of foreign exchange strategy with ING, said in a note. "Whether it goes far enough remains to be seen."

The relatively small banks that fell short of the capital-adequacy threshold of 6 per cent - five in Spain and one each in Germany and Greece - will have to raise a combined €3.5-billion ($4.7-billion) in new capital to cover the potential shortfall.

That is far less than analysts had estimated. Before the results were published, J.P. Morgan Cazenove put the weak banks' total potential capital needs at €40-billion. Barclays pegged the figure at €80-billion.

The large number of passing grades came as no surprise, analysts and economists said. European banks have been shedding debt and raising capital for some time, and most maintain capital ratios well in excess of required levels.

In the adverse scenario used in the test - no EU growth this year and a decline of 0.4 per cent in 2011, sharply higher financing costs and a stiff haircut on equities and troubled sovereign bonds held in trading portfolios - aggregate Tier 1 capital, the banks' cushion against financial shocks, would slide to 9.2 per cent at the end of 2011 from 10.3 per cent in 2009, said the Committee of European Banking Supervisors, which oversaw the exercise involving regulators and banks in 20 countries.

The problem for analysts is that it is difficult to compare the true health of banks across borders. Required disclosure is minimal, national regulations differ and accounting standards vary, making it hard to tell if the test results mean anything, some analysts say.

"This isn't about capital. This isn't about risk. This is an exercise to try and give investors something to hold on to, in terms of being willing to deal with institutions in each country," said Christopher Whalen, a managing director at Institutional Risk Analytics of Torrance, Calif.

The key is not how equipped an individual bank is to weather future storms, but the financial system itself, as well as the government backstopping it.

"It's all very well to look at this from an institution by institution perspective," said Mark Cliffe, chief economist with ING in Amsterdam. "But what we have been through has been a systemic event. That makes it fundamentally different from looking at one bank in isolation."

Jose Manuel Amor Alameda, an economist at Madrid's Analistas Financieros Internacionales (AFI), said he is "pessimistic" about the EU banks' long-term health despite the test results. "Anemic growth, deflationary pressures, more deleveraging, [private investment] crowding out by the public sector and high volatility do not bode well for the banks in the long run," he said.

"The market concerns are especially focused on the Spanish cajas and German landesbanken," said Marco Annunziata, UniCredit's chief economist in London. "If these localized problems are not uncovered and addressed, there is still a risk that we might see tensions resurging."

Mr. Annunziata said the U.S. seems to have avoided its own Japan-style lost decade by moving aggressively in 2009 to identify weak banks and get them recapitalized. "Japan left the zombie banks around for way too long, whereas in the U.S. they intervened decisively and the [banking] system seems to be getting stronger already. Europe is still somewhere in the middle."