The Committee of European Banking Supervisors (CEBS) yesterday published the parameters of the stress tests it is carrying out. 91 EU banks, which collectively represent 65% of the EU banking sector by assets, will be tested. The results of the stress tests will be announced on 23 July 2010, both on an aggregated and on a bank-by-bank basis. The market has keenly been awaiting news of the criteria CEBS would use in its tests, with investors looking to see if they will be sufficiently rigorous, particularly on the crucial question of sovereign default risk. The key question, therefore, is: has CEBS gone far enough to make the stress tests credible?

CEBS disclosed that the adverse scenario used in the tests assumes GDP growth three percentage points below current forecasts over the two-year horizon. So instead of the European Commision’s current forecasts for EU-wide GDP growth of 1% in 2010 and 1.7% in 2011, CEBS’ adverse case assumptions presumably allow for a decline in GDP of 2% in 2010 and 1.3% in 2011. And while CEBS did not go into specifics on sovereign default risk (such as the haircuts applied to various sovereign bonds), it did say that the parameters used represent "a deterioration of market conditions as compared to the situation observed in early May 2010".

CEBS' statement looks good as far as it goes: certainly the GDP assumptions appear rigorous enough to satisfy the market. And the promise to use conditions worse than those prevalent in early May at the height of the Greek crisis when testing sovereign default risk also looks suitably tough (see chart below).

PIIGS’ sovereign 2Y government bond yields

Source: Bloomberg

So far, so good – but doubts remain. The lack of detail pervading the document is somewhat concerning. It has allowed investors to latch onto rumours that the haircut on Greek sovereign bonds will only be around 17% (much less than the 40% the market is currently pricing in – see article), despite the fact that CEBS’ wording clearly suggests that the tests will incorporate something much more severe. We also do not know the capital base which will be regarded as necessary to pass the tests. In short, the woolly nature of CEBS’ announcement has allowed some in the market to conclude that the Committee is still struggling to agree on the stress tests’ precise criteria, but felt pressurised into rushing out an early statement.

Our view, however, is that this document shows a broad recognition by the CEBS that the tests need to be tough. A lack of rigour would render the entire exercise pointless. The fact that spreads have tightened slightly since CEBS’ announcement suggests that the majority of investors share our cautious optimism. And perhaps more importantly, official confirmation of the publication date means that the end is now in sight for the markets. Within a fortnight, they will have the results of the tests. Providing that, once the results are made public, any necessary capital injections are forthcoming, they will be able to sit in judgement on Europe’s banking system with all the facts – and, hopefully, much more strongly capitalised banks – before them. The full transparency the market craves could be just around the corner.

Nick Smallwood, Credit Analyst

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