After all the excitement that the banking world has generated over the past couple of years, the biggest surprise following the announcement of the stress tests’ results was that the banking authorities managed to create perhaps the greatest anti-climax that markets have witnessed this year. Across Europe, just seven banks "failed", including Germany's already-nationalised Hypo Real Estate, Agricultural Bank of Greece and five Spanish cajas (meaning that, under the adverse scenario, their Tier 1 ratio fell below 6% by end-2011). Several lenders that had been expected to fail the test scraped through. So was this arduous process really worth it?

At first, the answer seemed to be “no”. The macro economic projections used in the tests turned out not to be as tough as we had expected (see table below), forecasting a mild recession in the adverse scenario, while the tests put the total capital shortfall across the continent at a mere €3.5bn, just 10% of the lowest analyst estimates. The tests included sovereign bond haircuts of all European nations, including around 23% for Greece and 12% for Spain. However, the authorities avoided the politically contentious issue of addressing sovereign default risk, which they do not regard as possible, by applying these haircuts to banks’ trading books only – when most of the higher-risk paper tends to lie on the banking books to avoid mark-to-market volatility. And sovereign default risk was one of the key questions that market participants had wanted to be tested. The other notable omission was a test on the quality of banks’ capital (i.e. the balance between equity/retained earnings and hybrid capital). This omission explains why the likes of the German Landesbanken, some of which had been expected to fail, passed comfortably.

Key macro-economic assumptions used in stress tests

Source: CEBS

The fact that several key measures were ignored meant that the immediate consequences of the stress tests have been negligible. The tests have failed to uncover any new problems or provide any game-changing solutions to some lenders’ well-known failings. In short, they have added little to what we already knew, which is why markets largely appear to have ignored the results. As was the case last week, financial credit spreads continued to tighten gradually. And at first glance the funding scene is little changed: Euribor rates continued their seemingly inexorable series of daily increases. The tests have done nothing immediately to strengthen banks’ capital bases or loosen funding conditions.

So have they been a waste of time? Not entirely. First, the market has been given a snapshot – however incomplete – of European financial institutions’ relative strength. This should help the stronger institutions who were struggling to fund themselves at reasonable rates due to sovereign concerns, such as BBVA, to re-access the capital markets, while the weaker institutions are unlikely to see much change from their previous situation. Indeed, the market may yet force the necessary recapitalisation from which European regulars shrank. For now, investors are taking comfort from European authorities’ evident determination not to allow the failure of any sovereign or major financial institution. And second, the stress tests have provided much more transparency than before, notably on banks’ sovereign debt holdings. All European banks (apart from six recalcitrant German institutions) have published lists of their holdings of European sovereign debt, split out between the banking book and the trading book. This should allow any dissatisfied investors to calculate each bank’s potential losses in case of sovereign default for themselves if they wish to do so, making up for one of the tests’ key omissions.

The amount and quality of the data published – rather than any arbitrary “pass/fail” score – was always going to be the key to the success of these stress tests. It is transparency that the market craves. Over the next few weeks, as the results are digested, we would not be surprised to see an overall upturn in markets as investors feel better able to distinguish between various banks’ riskiness. While the stress tests have not had the spectacular impact that many hoped for, they may in time turn out to have been an important tool in easing European banks’ funding conditions – in which case, this rather agonising process will certainly have been worth it.

Nick Smallwood - Credit Analyst

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