The low failure rate raises questions about the leniency of the stress test exercise

THE EUROPEAN authorities have declared that the region’s leading banks are in a safe fiscal place generally, although seven institutions need fresh capital. The key question now is whether the results satisfy the markets. On that the jury is still out.

Fewer banks than expected failed the examination, leading to some scepticism last night and claims that the tests were no more stressful than a weekend of rest and relaxation. This was always likely to be the case, however.

In the long months of turmoil since Greece stunned Europe by admitting it falsified its books, the markets gave scant credence to soothing words from EU leaders. Indeed, the Greek bailout and the €750 billion rescue net for other distressed countries mark a collective failure by EU leaders to make a convincing case that the euro’s foundations remained solid.

The opposite was true – and the markets made that assessment long before EU leaders acknowledged it was so.

With all that as the backdrop, the authorities faced a daunting task as they prepared last evening to publish the results of the tests.

A feature of this exercise, however, is that a significant amount of new information about Europe’s banks and their sovereign debt holdings has been put into the open by national regulators. This will be an important comparative tool.

Given that the market participants invariably conduct their own analyses, the private analyses that follow will at least be based on a more transparent universe of information. Even if the ultimate recapitalisations prove greater than the modest transactions suggested last night, they might have the same desired impact as EU tests.

In a joint statement, the European Central Bank (ECB), the EU Commission and the Committee of European Bank Supervisors (CEBS) confirmed “the overall resilience of the EU banking system to negative macroeconomic and financial shocks”.

In reality there’s little new in that, for Europe’s banks have been gulping down massive amounts of public capital since the eruption of the financial crisis. There truly would be meltdown if the system was not shown to be resilient overall.

The authorities’ objective, however, was to bolster confidence by removing unfounded suspicion of well-capitalised banks. They also wanted to shine light on residual pockets of vulnerability, clearing the way for fresh recapitalisations if necessary. That governments would be on the hook for capital if private investors didn’t step forward is but one of the risks in the exercise.

For all the claims of rigour, the tests are inherently subjective as the outcome is coloured by parameters chosen. As it happens, the selected “what if” criteria point to a comparatively small need for fresh capital. This may be good news for European taxpayers but raises inevitable questions as to whether the exercise was too lenient.

This is particularly so because the assessment took account only of potential sovereign losses on the government paper that banks trade. The shock impact on sovereign holdings in their bank books, where the debt is typically held to maturity, was not examined. This fuelled market suspicion.

As predicted, Spain’s regional lenders proved weak. Known as cajas, five of them failed the test and their recapitalisation is likely to speed a long-awaited sectoral restructuring. Even though anxiety about the landesbanken network of savings banks was behind Berlin’s reluctance to engage in the stress tests, all of them passed and the ailing Hypo Real Estate was only German lender to fail. In Greece, only the state-owned ATEbank flunked.

Bear in mind that analysts predicted between €30 billion and €90 billion would be required to stabilise the sector. The tests suggest nothing approaching that kind of money is required, the combined total shortfall amounting to some €3.5 billion. That’s a tiny sum, considering the exercise examined 91 banks with 65 per cent of the total assets of the EU banking sector as a whole.

By way of comparison, Bank of Ireland and Allied Irish Banks each received an equivalent amount from the Government last year. Multiples of that sum are going into the nationalised Anglo Irish Bank. That’s another story.