David Prosser: Europe's stress tests may simply undermine confidence in the banks

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The Independent Online

Outlook The best-known witticism of Warren Buffett is his observation that it is only when the tide goes out that one finds out who has been swimming with no trunks on. The stress tests that the Committee of European Banking Supervisors (Cebs) has been putting 91 European banks through, the results of which will be announced this afternoon, are an attempt to pre-empt such nasty surprises.

Having asked Cebs to look at what would happen to Europe's banks in the event of various unpleasant shocks, the European Commission will force the skinny dippers to put some trunks on before the tide really does expose them. In the process, the Commission reasons, it will restore confidence in Europe's banks.

A similar exercise in the US last year proved to be an effective way of drawing a line in the sand. With certainty about the finances of America's institutions, confidence was restored in those judged sound and those found less so were able to recapitalise.

Will Europe's experience be so positive? There are good reasons to fear not, given that the Commission was dragged kicking and screaming into ordering these tests, which are an extension of a previous exercise, after regulators failed to convince the world their judgements of the soundness of the banks were enough.

Moreover, we have not had full disclosure of what the stress tests have actually entailed – certain detail has been made public, but we still don't know exactly what scenarios Cebs has been testing. Without the detail, how much store can we set in the results?

The lack of transparency is important. If no one fails the tests, the market reaction is likely to be scepticism, undermining the whole point of the exercise, to instil confidence. If, as is more likely, the tests expose weaknesses amongst some of Europe's smaller institutions, such as Spain's cajas, there will still be doubt about whether Cebs has been sufficiently rigorous – should more banks have failed? – and there will be the additional question of what to do about the problem cases.

On the latter issue, there has not been much discussion of how weaker banks might be strengthened. It is difficult to imagine governments in countries such as Spain, already under such pressure over the state of their public finances, finding the funds for another bailout. Nor is there much appetite in the market for private sector fund-raising.

All in all, the impact of the stress test results may be the opposite to what was intended. If too many banks pass, people won't find them credible. If there are failures, how do we turn them into passes? Damned if you do, damned if you don't, in other words.