Do European banks need tougher stress tests?

Eight European banks flunked a financial health check meant to reassure investors. But critics argue for tougher tests to weigh the impact of a sovereign default.

The European Banking Authority (EBA) says 8 out of 90 banks in the European Union failed a stress test, designed to check the robustness of financial institutions in times of crisis. Another 16 banks were in the danger zone, the London-based EBA added. Five of the failed banks are in Spain, two are in Austria, and one is in Greece.

The stress test and the EBA itself were created after the global financial crisis of 2008, triggered by the collapse of investment bank Lehman Brothers. In the test the EBA plays through a number of scenarios, assuming a drop in economic growth and falling share prices, a devaluation of the dollar, and a shrinking real estate market. Banks that take part in the test are expected to hold at least 5 percent equity capital as a financial cushion.

The tests are meant to provide information for investors on the state of health of Europe’s top lenders. But the US-based ratings agency Standard & Poor's issued a statement, arguing that tougher testing was needed.

"We consider that the European Banking Authority has pitched its stress scenarios at a level that attempts to be sufficiently tough to reassure markets, but not so stringent as to suggest material capital shortfalls," the agency said. "We consider that a moderately harsher scenario would add greater value in terms of assessing the resilience of the European banking sector."

It is the second time such a financial health-check was conducted, and the EBA said it is already using tougher tests than last year. In 2010, only 7 out of 91 banks failed the test. Among those who passed were Bank of Ireland and Allied Irish Bank (AIB). A few months later AIB had to be bailed out by the Irish government which itself shortly after had to turn to the EU and the International Monetary Fund (IMF) for financial aid.

In an attempt to tighten the rules this year, the EBA did not accept debt-equity hybrids, known as “silent participations,” as a form of core capital. This caused German bank Helaba to pull out of the test and ask the regulators not to publish its results.

One thing the test didn’t simulate was a sovereign default. A Greek bankruptcy, a certainty to many observers, is still taboo for Brussels.

“The stress test is a pretty blunt instrument,” says Professor Hans-Peter Burghof, chair of the Banking and Finance Department at the University of Hohenheim. “And what’s more, the test was designed with certain political motives. Of course a Greek default is not part of the scenarios, because that would expose certain banks holding lots of Greek debt.”

Critics also argue that the capital shortfall revealed by the stress test amounts to 35 billion euros ($49 billion), a small part only of the 110 billion euros ($155 billion) Greece needs for its second bailout package, currently debated by European governments.

The result of the stress test came just as the Italian parliament approved an austerity package of 48 billion euros ($68 billion) to prevent the country from being pulled into the vortex of the European sovereign debt crisis. Italy’s central bank said that all Italian banks had comfortably passed the test.