Leading article: Only realism will calm the financial markets

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Once again the stress tests have failed their own stress test. Last Friday's report from the European Banking Authority (EBA) on the health of the continent's banking sector has not convinced the international capital markets that (with a handful of exceptions) Europe's financial institutions are basically healthy. The share prices of European financial stocks all fell yesterday the moment markets opened. Meanwhile, Italian and Spanish interest rates rose.

And it is small wonder. The EBA's stress scenarios did not even include a sovereign debt default by Greece, despite the fact that the financial markets now consider such a move by Athens to be a virtual certainty. The only possible reason for such an omission is that politics, rather than economics, were driving this process.

The amount of extra capital that the EBA said was needed across the system – 2.5bn euros – was also implausibly low. This was even less than the 3.5bn euros recommended by last year's banking stress test, which is now universally regarded as a sham. The fact that the EBA even allowed one German bank to opt out of the test altogether also underlined its weakness.

Given all this, the surprise is not that the tests failed to calm the markets, but that European policymakers ever imagined that they would. All the signs are that the European establishment still does not get it when it comes to the existential challenge faced by the eurozone. They seem to imagine that presentational exercises such as stress tests, if done with enough fanfare and conviction, will calm the increasingly panicked bond markets. But the fact is that markets will not be calmed until there is some realism and substantive action from Europe's leaders.

That means an acceptance that some nations – most likely including Greece, Ireland and Portugal – need debt relief and lower interest rates if they are to stand any chance of staging an economic recovery. It also means an acceptance from the European establishment that banks across the Continent that hold the sovereign debt of these nations need a major capital injection. Finally, it means Europe's leaders must face up to the imperative to make the eurozone's fiscal union stronger for those nations that are still solvent, and to allow those that are insolvent to leave the single currency.

Despite the tough talk, the latest stress tests turned out to simply more of the same from the European establishment. And it has been abundantly clear for some time that more of the same simply will not work.

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