Stressing the stress test

Europe's bank stress test warrants a narrow pass

Europe's landmark assessment of its banks just about scrapes the credibility test. The analysis undertaken by the European Central Bank (ECB) and the European Banking Authority (EBA) has failed just enough lenders to keep the cleanup project moving. Unfortunately, that does not guarantee a return of investor confidence to the sector, nor a sudden switch by European banks from deleveraging to lending.

The headlines are a euro 25-billion capital hole, with 24 lenders failing to achieve a 5.5-per cent core Tier 1 ratio after the EBA's "adverse" economic scenario and another failing the ECB's so-called asset-quality review. This is less stressful than it appears. The figures are based on banks' December balance sheets and don't include capital raised since. As of today, the capital shortfall is only euro 9.5 billion. And one-third of that comes from Greek banks that have restructuring plans, which largely address their issues.

Adjust for all this and the overall quantum is disconcertingly similar to the euro 2.5-billion deficit following the EBA's 2011 stress test, which was much derided for its weakness. With the exception of Italy's Monte dei Paschi, all the big names - Barclays, BNP Paribas, Deutsche Bank, Santander - passed comfortably. UK banks like Lloyds Banking Group, which reported a 6.2-per cent post-stress capital ratio, are more secure than they look: their home regulator insisted on a tougher definition of capital than euro peers faced.

Two factors make this exercise more credible. First, the mere threat of failure prompted over euro 200 billion of capital-raising since mid-2013. Second, the latest test assumes a macroeconomic shock only after harmonising how each of the 18 member-state banking systems calculate bad debts. The latter didn't happen previously.

Monte dei Paschi symbolises the change. The new standard for bad debts knocked over three percentage points off the Italian lender's pre-stress 10.2-per cent core Tier 1 ratio. Stressing the adjusted balance sheet left a euro 2.1-billion deficit, even though the bank raised euro 5 billion earlier this year. Such pain at the world's oldest bank leaves the ECB, which will regulate the euro zone's biggest banks as of November 4, with a veneer of toughness.

That said, ECB President Mario Draghi was once head of the Bank of Italy. And If the ECB wants to keep looking tough it will have to be more robust next time. A really tough regulator would not have allowed banks in the euro zone periphery to count deferred tax credits as capital. Concessions on shipping loans and collateral have also weakened the end result, and it's striking that only one German lender failed the exercise.

It's possible that after nosing through the reams of balance sheet disclosures foreign investors will feel confident enough to invest more in European banks. But the real benefit of a cleaned-up banking system - banks extending more credit, especially to small businesses - may not materialise. The macro test did not assume overall deflation in the euro zone, even though it's almost happening already. If the economic climate keeps deteriorating, banks still won't lend and some may go bust. The ECB has avoided looking weak right now, but that doesn't mean it won't in the future.