David Prosser: The tightrope walk of stress-testing Europe's banks

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The Independent Online

Outlook For the next key moment in the eurozone crisis, which comes today, look to Europe's banks rather than its sovereign debt-issuing governments. This morning, the European Banking Authority (EBA), the new European Union regulator, publishes the results of the latest round of stress tests conducted on more than 90 banks in 23 countries.

In an ideal world, we will get a mix of good and bad news, but not too much of either. Were the EBA to give all 91 banks a clean bill of health, no one would believe them – the stress tests would then do more harm than good. Equally, if the tests reveal that Europe's banks are much weaker than we thought, the result will be yet another escalation of the eurozone crisis. It's quite a balancing act.

Nevertheless, this is a tightrope that Europe has no choice but to walk. What's driving the crisis is the fear of what sovereign debt defaults might do to banks' balance sheets – and above all, that their exposure to defaults might prompt another systemic financial crisis in which institutions begin to fall like dominoes.

There has been a fair amount of scepticism about these stress tests, which is understandable. After all, within months of the stress tests run last year by the Committee of European Banking Supervisors, several Irish banks that passed had to be bailed out.

This time around, the tests look more credible. They make more exacting demands in terms of capital, one reason why European banks have been raising funds in recent months. More importantly, they require the banks to model for much tougher stresses, particularly on the potential effects of sovereign debt defaults and rating downgrades. We will also get much better disclosure of who has exposure to what in Europe.

The result, one assumes, will be more failures than the seven that missed the cut last time around – maybe three times as much. Britain's banks will all pass, but institutions in Spain, Germany, Italy, Portugal and Ireland are struggling to make the grade.

That need not be disastrous, if the announcement of failures is accompanied by convincing plans for putting the problems right – and finance ministers have already promised properly to capitalise the weaker banks within six months of today's announcement.

Nevertheless, there can be no disguising the fact these tests are likely to show between a fifth and a quarter of Europe's largest banks are still not sufficiently robust. In the longer run, we will benefit from better visibility of the problems (and the solutions applied) but in the current febrile market conditions, the stress-test results could prove to be yet another painful jolt.

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