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European Banks are About to Undergo a New Round of Stress Tests, Do You Feel Confident ?

“The European Banking Authority presented the outlines of this year’s stress test for the European Union’s biggest banks, but said it would be for national supervisory authorities to guarantee the reliability and credibility of the exercise.

Although the stress test is an EU-wide exercise, it will be most notable for its place in the European Central Bank’s preparations to take over responsibility for supervising the euro zone’s largest banks. The ECB is conducting an in-depth Asset Quality Review across the euro zone to check that banks have properly reported any weaknesses they may have on their balance sheet. It aims to start supervising in November this year, on the assumption that the stress test’s results will show in October how much capital banks still need to raise.

The ECB is due to announce more details regarding its work in the exercise next week.

As in previous years, the stress test will be designed to show whether banks can keep an adequate level of capital in the event of a sharp economic downturn and market shock.

The test will consist of two scenarios running through three years, 2014-2016: the baseline scenario will be drawn from the European Commission’s forecasts, while the adverse scenario will be designed by the European Systemic Risk Board, the EU’s “macroprudential” supervisor.

To “pass” the test, banks will have to show a ratio of 8% in core Tier 1 capital relative to their risk-adjusted assets in the baseline scenario, and 5.5% in the adverse scenario. The exercise will take as its definition of capital the EU’s latest Capital Requirements Directive, which came into force at the start of this year. That directive is the EU’s implementation of the globally agreed “Basel III” accords on banking capital and liquidity. One of its characteristics is that some capital instruments common to European banks are being phased out in a transitional period that runs through 2018. As such, banks will have to show in the test that they are migrating to newer, more recognized forms of capital at the desired speed.

The test will examine 124 banks across the EU, covering at least 50% of banking assets in each country. For banks operating in multiple countries, only the parent bank will be scrutinized.

If they desire, supervisors won’t only be able to add other banks in their jurisdictions to the list, but also to add completely different test metrics. The U.K.’s Prudential Regulatory Authority, for example, has said it is likely that it will also test banks on their leverage ratios, a measure of capital adequacy that doesn’t allow banks to adjust the value of their assets for riskiness. Leverage ratios have come into vogue in recent years due to suspicions that banks are using the benchmark risk-adjusted metrics to overstate their financial strength….”

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