Europe raised the bar for its banks, demanding more, better-quality capital in a test aimed at reassuring taxpayers the sector can withstand future recessions - and setting up struggling state-owned German lenders to fail. The European Banking Authority (EBA) said on Friday banks must prove they hold more than 5 percent of core Tier 1 capital to pass an exam imagining a two-year recession, a collapse of property prices and rising unemployment.
It also said it would exclude much of a hybrid debt-equity type of capital used by many German state-owned banks and seen as controversial because critics say it may not absorb losses when needed. Public sector lenders Helaba and NordLB will struggle to pass the tests because of this. NordLB has signalled it will convert its holdings, known as "silent participation" to improve its capital position. A spokesman for the finance ministry in the German state of Hessen, where Helaba is based, said, "We stand by Helaba and will not allow a European authority which has overreached its authority, to threaten the existence of Helaba."
The EBA wants to be seen as tough after last year's health check flopped - Irish and Portuguese banks passed despite subsequently needing massive bailouts - and thus is using a definition of capital that is more stringent than last year. It said the 5 percent pass mark for core Tier 1 capital is comparable to the standard set for US banks under their recent exam.
However the US banks that passed last month's test were allowed to bump up dividends or buy back shares. In contrast, European banks are being encouraged to keep conserving capital. The EBA will also decide how many of Europe's banks need to raise capital, sell assets or shrink their loan book to make them strong enough to withstand economic headwinds. The exercise is already having an impact.
Even though few banks are expected to fail, many are bolstering their capital, including 'near misses' - weak banks who are looking to take pre-emptive measures. Capital-raising plans unveiled by the end of this month can be included in the heath check. Germany's Commerzbank AG and Italy's Intesa Sanpaolo this week unveiled plans to take action.
Regulators and governments are also lining up extra help. EBA Chairman Andrea Enria, who briefed EU finance ministers in Hungary on the plan on Friday, wants governments to have plans ready to fund the banks which need it. Banks have until the end of this year to discuss raising cash privately, selling assets or deleveraging to bolster their capital position.
Jean-Claude Trichet, president of the European Central Bank, said it was up to national governments "to stand ready to do whatever is necessary" to fix problems shown up by the test. Mike Harrison, bank analyst at Barclays Capital, said the test was more strenuous than a year ago.
But he added it was still hamstrung by political issues that made it unable to stress test the sovereign debt banks hold on their banking books - because governments do not want to spook markets by contemplating even a theoretical sovereign default. "People aren't losing sleep over a double dip recession, they are losing sleep over sovereign risk," he said.
Four more banks will be added to those tested last year. Ireland's Irish Life & Permanent, Austria's Volksbanken and Denmark's Nykredit will be tested, as will DnB NOR, even though Norway is not part of the EU. Europe's listed banks are expected to raise at least 40 billion euros this year and Spain's private savings banks, or cajas, will raise a similar amount, according to a majority of investors polled at a top conference last month.
Portugal's economic troubles have raised fears the capital level of its banks will be eroded by low economic growth and rising bad debts, and need bolstering. Friday's announcement was preceded by a round of bickering among European Union countries about what should constitute core capital - which varies among countries but mainly comprises common equity and retained earnings.
Germany in particular sought exceptions for its system of publicly owned regional banks, the Landesbanken. Up to the last minute the Berlin government, Bundesbank and German regulators insisted on allowing "silent participation" to count as core capital. They account for a quarter to half of the capital reserves of the Landesbanken, savings banks, co-operative banks and private banks.
On Friday the EBA said it had set the most consistent definition of core Tier 1 capital possible. To qualify, capital must be simple and readily available. Thus complex forms like silent participation issued during the financial crisis will not be allowed. However silent participation issued post-crisis by the German government are acceptable.
Four more European banks will be added to those tested last year. Ireland's Irish Life & Permanent, Austria's Volksbanken and Denmark's Nykredit will be tested, as will DnB NOR, even though Norway is not part of the EU. Banks must hold a minimum of 7 percent core Tier 1 capital under new global capital rules known as Basel III, from January 2013, though countries such as Britain and Switzerland have already put the bar at 10 percent or more.
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