Saturday, July 24, 2010

Euro−Zone Stress Tests Released, 7 Banks Fail But Criteria Questioned

Forex Special Coming into this week the talk in currency markets was the Euro-zone bank stress tests and their results.

A result in which all banks passed would be seen as too lenient and would not go far enough to restores confidence in the Euro-zone financial system. However, if too many banks failed the criteria it could spook investors as they see the Euro-zone banking sector still mired in the sovereign debt crisis.

Well, after much speculation we finally have the results.

As expected the German bank Hypo Real Estate failed. All French, Portuguese, Swedish and Irish banks passed.

In Spain we had several banks failing including Diada Savings, Espigna Savings Bank Group, UNNIM Group, Banca Civica and CajaSur. Now Spain has moved already to consolidate its banking sector and has set up funds to facilitate that process. Spanish banks were particularly hard hit by the crisis as a large housing bubble left Spanish financial institutions with many bad loans on their books.

Finally, one Greek bank ATE Bank also failed the requirements.

In all the failed banks will need to raise a total of 3.5 billion Euros. Failure of the test meant that under the adverse conditions laid out after a sovereign shock, banks would see their Tier 1 capital ratios fall below 6%, a threshold that is above the regulatory minimum of 4% Tier 1 capital.

Earlier in the session the Euro floundered as details of the tests methodology became known. It led some investors and traders to question whether the tests were stringent enough. While the test scenario assumes a double-dip recession, a 20% decline in equity markets and a sharp rise in interest rates, the main drawbacks being that the tests would not treat the impact of sovereign debt losses on trading books and bank books equally.

While default was not an option in the stress tests, the tests did assume a haircut, or discount, of 23.1% on Greek bonds at the end of 2011, reports said. The haircut on Portuguese bonds is set at 14%; Spanish bonds, 12.3%; and German bonds, 4.7%, reports said.

Second, bank-book assets would not be marked down in the same way as trading-book assets because they are assumed to be held until maturity, whereas trading-book assets have to be marked as their prices fluctuate and losses are reflected in banks’ quarterly earnings. But, bad bond purchases could have been stuffed into the bank’s portfolio while profitable trades were left as trading-book assets.

Following the results, we had some choppy trading, which is not unusual in the immediate aftermath of major news or data, as initial movements often reflect positioning and knee-jerk reactions which investors may cast aside once they’ve had time to sift through the details of the report.

By 1 PM EDT time, the EUR/USD was trading near its low for the day, as banks that were suspect passed the tests, meaning the credibility of the tests may pressure the value of the Euro. A high-profile failure or two and several tens of billions of capital needs would have been greeted as more realistic from the market.


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