Spain's debt downgrade puts pressure on regulators

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The Independent Online

Yesterday's downgrade to Spain's sovereign debt rating puts extra pressure on regulators devising tests for how Europe's banks will cope with future shocks.

Analysts argue that any tests of banks' ability to withstand economic turbulence should include a country failing to pay its debts to banks that hold its bonds.

However, the toughest scenario being considered is a "haircut" on sovereign debt in which banks lose out on some of the value of the bonds.

The European Banking Authority is due to present its scenarios to banks today with further changes possible before it publishes final scenarios in a week's time. EBA insists they will be tough enough.

James Babicz, head of risk at the consultancy SAS UK, said: "You have a scenario that is being played out right now [on sovereign debt]. You can't have a stress test for a real economic shock unless you take into account a sovereign default or a downgrade."

Rating downgrades increase countries' costs of borrowing that can cause a vicious spiral of spending cuts, stalled economic growth and further downgrades.

Countries' efforts to protect their own banks threaten to weaken the tests and undermine their credibility. The first round of tests a year ago gave a clean bill of health to Ireland's banks soon before the Irish IMF bailout.

Germany is lobbying for a capital instrument peculiar to its banks to be counted as part of loss buffers even though those reserves would not be used until shareholders' funds are wiped out.