Time for a trim?

EU stress tests: Europe’s banks can mostly deal with a fat haircut on their holdings of Greek sovereign debt. That’s the conclusion of a Breakingviews analysis of data disclosed by lenders under the European Union’s latest stress tests.

Officially, just eight banks failed this year's stress tests, with a capital shortfall of euro 2.5 billion. But the exam had a major flaw: it did not require banks to apply a haircut to the majority of their holdings of euro zone peripheral debt. That’s at odds with reality: any revised bailout package for Greece is likely to force banks to recognise at least some losses on their debt.

The Breakingviews test shows what would happen under such a scenario. It takes the banks' holdings of sovereign debt in their banking books and applies a haircut to Greek, Portuguese, Italian, Spanish and Italian bonds, based on where the countries’ 5-year bonds were trading last Friday. The value of Greek bonds, for example, is slashed in half.

As a result, the Breakingviews test shows 27 banks failing the test, with an overall capital hole of around euro 25 billion  — 10 times the official number.

That sounds scary. But the biggest problem is in Greece itself, where the resulting capital hole is euro 13.6 billion. This is not much more than the euro 10 billion that Greece has already set aside to recapitalise failing banks.

There’s also a knotty problem for Cyprus. The two Cypriot banks covered by the test would face a capital hole of euro 2 billion. Although that’s 11 per cent of GDP, the government’s own debt is 61 per cent of GDP, so it could stump up the cash if it had to.

Portugal and Spain also take a hit under the Breakingviews test, with capital shortfalls of euro 3.3 billion and euro 6 billion, respectively. But in the context of those countries' economies, that is not a huge amount.

Investors may quibble with some of Breakingviews’ assumptions. In particular, some may feel the pass mark core Tier-1 ratio of 5 per cent is too low. Raise it to 6 per cent, and the number of failing banks jumps to 38, and the capital hole goes up to euro 45 billion.

The tests do not mean that euro zone leaders can just merrily let Greece default. They need to recapitalise their banks sufficiently to deal with such an event — not merely to deal with the stresses envisaged in the official tests. And, they need to put in other firewalls to deal with the second-order impact of a default. If they do that, a Greek default need not be a disaster.