Skip to main content

Q&A: Europe's banks 'stress-tested'

By Paul Armstrong, CNN
Click to play
EU bank stress test explained
  • Seven banks - five from Spain, one German and one Greek - fail stress test
  • Designed to assess how each bank would fare in another economic downturn
  • Banks in the United States tested last year, with 10 told to raise more capital
  • European Union hopes tests will restore confidence in banking sector

(CNN) -- European regulators issued report cards Friday following a month-long examination of 91 major banks across the region.

A total of seven lenders, including five smaller Spanish banks, failed the so-called "stress tests," designed to rate how they would fare in another economic downturn.

Last year, ten of the 19 biggest U.S. banks -- including Wall Street titans Bank of America and Citigroup -- failed similar tests, and were found to have shortfalls of around $75 billion in their cash reserves, according to the U.S. Treasury.

Stress test results revealed

Despite this apparent setback, the failed U.S. banks' stocks were actually boosted as investors took confidence from the transparency the tests provided, and the fact the banks required less new capital than previously feared.

What did the test involve?

Banks that failed 'stress test'
Spain: Banca Civica, Diada, Espiga, Unnim, Cajasur.

Germany: Hypo Real Estate

Greece: ATEBank

The Committee of European Banking Supervisors (CEBS) said it tested the banks' resilience during various "what if" scenarios, including a "double-dip" recession within the EU which sees its economy contract by 3 percent until 2011.

If the banks' capital is all but knocked out then they will fail the test and be asked to increase their cash -- or capital -- reserves. This could be done through issuing new shares.

In their tests in 2009, American banks had to assume the U.S. economy would contract by 3.3 percent and remain almost flat the following year. They also had to assume that housing prices would fall an additional 22 percent and that unemployment would increase to 8.9 percent in 2009 and hit 10.3 percent in 2010.

Which banks were tested?

Ninety-one banks of varying size representing each of the member states, which equates to 65 percent of the EU banking sector.

The original plan was to test only the biggest lenders but concerns over many small and medium-sized institutions prompted the expansion.

Which banks failed?

Video: Europe vs. U.S. stress tests
Video: Banks to undergo test

Seven, including five Spanish savings banks: Banca Civica, Diada, Espiga, Unnim and Cajasur. Germany's Hypo Real Estate and Greece's ATEBank also failed.

Howard Wheeldon, senior strategist at BGC Partners, said most people expected a number of smaller banks across Europe to fail the test, and that the solution for many could be consolidation through mergers with other banks.

"In some countries there may be room for that," he told CNN. "In Germany for instance there is a need for many of the regional savings banks to merge. There are too many of them."

Why were European banks being tested?

The recent sovereign debt crisis that has engulfed a number of countries in the European Union -- including Greece, Spain and Portugal -- has raised fears that banks within the region are too exposed if these countries default on their debts.

As a result, CEBS, which gives advice to the European Commission on policy and regulatory issues related to banking, in collaboration with national regulators, assessed the resilience of the EU banking system to possible adverse economic developments, and looked at the ability of banks in the exercise to absorb possible shocks on credit and market risks, including sovereign risks.

They wanted to find out which banks -- the results have been published for each individual lender -- are carrying the most government liability, and whether it is German debt or Greek debt that sits on their books.

Europe's banking system is only just recovering from the effects of the global financial crisis of 2008, which ushered in the worst recession since the 1930s. Some of Britain's biggest lenders, such as the Royal Bank of Scotland, were effectively nationalized as they struggled to cope with mounting losses as the credit market dried up.

It has been a good exercise in waking up the banks, though I would prefer it was done through a more formal audit procedure.
--Analyst Howard Wheeldon

But there is broad agreement among EU members that the stress test results will help to restore confidence in the battered industry, while European Commission chief José Manuel Barroso said they should "reassure investors by either lifting unfounded suspicion or by dealing with the remaining problems that may exist."

How does the financial sector view the tests?

As with the U.S. tests last year, some analysts believe the tests are not rigorous enough.

"This isn't an audit process where someone's actually gone in to interview the banks and look at the books," said Wheeldon. "It's a self-regulatory procedure where the banks have given the information freely themselves. So I hope it's correct.

"If we wanted complete satisfaction then each bank would need to have been audited individually via the European Central Bank, or under the jurisdiction of the European Central Bank.

"Let's see it how this plays out first. But if the (CEBS) report says only two or three banks have failed then this will be a huge loss to its credibility.

"It has been a good exercise in waking up the banks, though I would prefer it was done through a more formal audit procedure."

But according to CNN's Jim Boulden, if many of the banks fail some people will question whether the exercise has done anything more "than scare an already fragile market."

Will the banks take notice of the results?

"There's no doubt that they will take full notice of whatever the EU or any other regulator says," said Wheeldon.

"They have no choice. If a government or a body such as the EU says your bank is not sufficiently strong enough to withstand certain economic conditions then you have got to do something about it, such as bringing in new money by issuing new shares."