July saw the presentation of the findings of the EBA (European Banking Authority) stress test – an analysis of the state of health of banks across the European continent.

Subjecting the banking system to a ‘medical’ is a good idea at the best of times, but much more so when times are tough and we’re all still trying to escape from the clutches of a nasty credit crisis. The recent exercise, executed on a European-wide scale, was therefore an important one, designed to check up on the state of Europe’s major banks and instil much-needed investor confidence in the continent’s financial institutions.

What is a stress test and how does it work?

A stress test of this kind is first and foremost an analytical tool aimed at detecting possible problems and providing advice and recommendations if they are found. It serves to seek out the offenders and try to get its house in order to once more present a credible banking system that investors can believe in.

In essence the stress test looks at each bank’s individual Tier 1 capital ratio – its equity capital relative to its total risk-weighted assets. Or in other words, the capital it holds as a proportion of its assets, which are weighted according to their credit risk. It is the mix of the bank’s assets that determines the weighting of the risk factor.

The EBA set its minimum solvency ratio at 5%, and then created two scenarios against which each bank’s capital ratio was measured. The first is the so-called Baseline Scenario, which measures the stresses against country-specific conditions as defined by the European Commission. These are based on the prevailing economic forecasts and under these circumstances virtually all the banks tested passed the 5% requirement.

However, a stress test would not be a stress test if it didn’t include a worst-case scenario in which the forecasts for economic growth, inflation, real estate price movements, stock exchange performance and the interest rates on public debt are made particularly grim. This scenario, drawn up by the EBA itself, is again adjusted to account for country-to-country variations, and it is this so-called ‘adverse scenario’ that the EBA stress test really hinges on.

The verdict

Although this scenario is by admission of EBA itself highly unlikely to occur, it is important that we test the solvency of our banks in the very worst of possible circumstances. What may have seemed virtually impossible a decade ago has recently come to pass, with the large-scale propping up of banks not just in Europe, but across the world.

In all, nine banks out of the dozens that submitted themselves to the EBA’s stress test failed, scoring a capital ratio of below 5% when tested against the adverse conditions scenario. The good news is that this is a relatively small number. The bad news is that five of them were Spanish, including the small, unlisted savings banks CAM, Unnim, CatalunyaCaixa and Caja3, and the listed Banco Pastor.

Fortunately they are all relatively small banks with a combined market share of just over 9%. Most did not score far below the 5% target, but if taken at its word the EBA recommendation is that they should move to inject capital holdings to improve their solvency sooner rather than later. Though the EBA recognises that there are other mechanisms besides capital injection that can be used to address the problem, the most straightforward solution is improving liquidity in the short run, for instance by the sale of assets or subsidiaries like some of the Greek banks have done in recent times.