Moment of truth as Europe learns depth of banking rot

LONDON - It is billed as a moment of truth - but some fear an exercise in obfuscation.

The results of European Union stress tests designed to uncover the depth of rot in the continent's banking system come out this week, and an accurate reading would go far to answering the key question of whether Europe's debt crisis is over.

Some experts expect gloom whatever the result: bad news could send markets into a tailspin again.

Too rosy a picture, on the other hand, may alarm investors that the tests have not been rigorous enough.

The hope is that the results are credible enough to lift the cloud of uncertainty surrounding the exposure of European banks to the debt crisis. US stress tests last year helped to shore up confidence after 10 of 19 banks failed tests and were told they needed to raise around US$75 billion ($105 billion).

Europe's debt crisis has already forced Greece to take a €110 billion ($200 billion) international bailout to avoid bankruptcy, and pushed governments to put up a $1.4 trillion backstop for troubled governments if they need it.

Greece's near-failure sent shivers of fear through investors wondering which banks' balance sheets were hiding Greek and other debt that could go bad.

Most of the 91 banks tested are expected to pass - but analysts say some must fail for the tests to have any credibility. And failure won't necessarily mean the banks are bust, but that they will need to raise money from investors or governments.

Raising more money would be an unpleasant reality that should not be dodged, said Nicolas Veron, a senior fellow at economic think-tank Bruegel in Brussels.

"If its outcome is to be credible, it will necessarily reveal significant capital shortfalls in a number of banks," said Veron. Analyst estimates range from €50 billion to €100 billion for new capital requirements.

Those perceived to be candidates for fresh capital injections when the tests are revealed are some of the smaller Spanish banks - the so-called cajas - hit by the real estate collapse, and regional German banks - the Landesbanken - that made oversized bets on global financial markets before the 2008 meltdown.

Cajas and the Landesbanken are not listed on stock markets and thus not subject to analyst scrutiny in the way that major banks such as Germany's Deutsche Bank, Britain's Barclays and France's BNP Paribas are.

Equally important will be the response from policymakers and the banks themselves..

"The announcement of the results needs to include a clear and detailed recapitalisation plan for those banks or national banking systems that did not prove resilient to the stress tests," said Silvio Peruzzo, euro area economist at the Royal Bank of Scotland.

Little is actually known about how the London-based Committee of European Banking Supervisors (CEBS) is conducting its analysis - in marked contrast to the tests that were undertaken last year in the US.

What is known is that the CEBS's "adverse economic scenario" assumes that the EU economy underperforms the EU Commission's forecasts by three percentage points of gross domestic output - in other words, a recession.

The key unknown is what potential losses the CEBS assumes banks will have to absorb from losses on their investments in government debt - Greek bonds, widely considered the most risky, are expected to have a "haircut" of around 20 per cent, while the discount for Germany is likely to be in the very low single-digits at most.

If the probability attached to a Greek debt default is too low, for example, then investors may dismiss the results and continue to worry about hidden losses. Equally, if the tests are too tough then investors will fret about how banks will be able to raise money to rebuild their capital.

"Stress testing is a gamble," said Ken Wattret, chief eurozone economist at BNP Paribas.

The euro has advanced over 10 cents since hitting a four-year low of US$1.1878 in early June on a combination of easing worries over Europe's sovereign debt crisis and concerns about the US economic recovery. On Friday, the euro broke above the US$1.30 mark for the first time since early May.

Neil Mackinnon, global macro strategist at VTB Capital, thinks the tests will be anything but "stressful" and, given the positive noises coming from many European capitals, increasingly look like they are going to be a "whitewash".

Mackinnon pointed out that the 20 per cent figure for the Greek "haircut" is way too low. Something nearer 50 per cent would be more realistic, he said.

- AP