Stressing Out over European Bank Stress Tests

The newly created European Banking Authority will be overseeing the stress tests on almost 90 European banks. Recall that the stress tests last year met broad criticism for the lack of rigor. It was anticipated that the EBA would indeed provide for a more robust test this year. However, doubts are already being raised.

Initially there are two areas of concern. The first is on the definition of Tier 1 capital, which is that part that can absorb unexpected losses. The early indication is that the EBA will likely allow countries to use their own definition of Tier 1 capital. The UK, for example, is believed to have a more stricter definition than say Spain. That would give Spanish banks an advantage.

The second area of concern is the level of stress to be measured. Reports indicate, for example, that banks will be tested for, among other things, a 17% loss on Greek debt. The last stress test reportedly has a 23% loss on Greek bonds. Moreover, the current 10-year differential is near 935 bp. That suggests that there is about a 55% chance of a 17% loss on Greek holdings. A rating agency previously warned of the risk of a 50% loss, which would help bring the debt/GDP ratio back into line the Stability and Growth Pact.

That said, given that the ECB purchases may be skewing price discovery process in the Greek bond market. Our analysis of the CDS market places the odds of a substantial haircut higher. That said, one may want to shade that as well, given liquidity concerns and the use of the sovereign CDS to also express on view on Greek banks. In any event, the point remains valid that at first blush the stress tests do not sound all that stressful.