* Scenarios for EU bank tests to be revealed on Tuesday
* Deflation, emerging market fears set to feature in tests
* Regulators aim to avoid optimistic scenarios of past tests
* Banks worried about sovereign debt treatment, GDP outlook
By Laura Noonan
LONDON, April 27 Fears of euro zone deflation,
emerging markets turmoil and a determination not to repeat past
mistakes mean European regulators are likely to come up with the
toughest set of tests for the region's banks that they have ever
The European Banking Authority (EBA) will on Tuesday reveal
the crisis scenarios that banks will have to prove they can
withstand without resorting to the kind of taxpayer bailouts
that all but bankrupted some countries in the 2008-2012 crisis.
Banks that fall short of capital under the imagined
scenarios will have to produce a plan to boost their reserves by
raising fresh funds from investors, selling assets or hanging on
to profits instead of paying dividends.
Banks have already raised billions in capital and made other
reforms ahead of the tests, which regulators hope will finally
banish any investor doubts about the industry and allow it to
refocus on lending to boost growth.
The European economy has rallied since the last round of
bank stress tests three years ago and sharply lower borrowing
rates for countries such as Greece - which can now borrow five
year money at an interest rate below 5 percent against the 20
percent it was paying when the 2011 tests were done - support
the idea that the worst of the euro zone crisis has passed.
But with widespread criticism heaped on 2010 and 2011 stress
tests for being too soft, and new risks on the horizon,
regulators are likely to set tougher conditions all the same.
"The key is that the scenario is at least as deep and dark
as the great recession, the financial crisis of 2008/2009," said
Mark Zandi, Philadelphia-based chief economist at Moody's
Analytics. "You can easily conceive a scenario as severe as what
we went through."
AS TOUGH AS THE U.S.
Figures leaked ahead of Tuesday's announcement show
regulators are taking a tougher line on economic growth than in
2011, when 18 of the EU's 27 countries at that time posted
weaker growth than the "adverse" case they were tested against
The most dramatic miss was Greece, where an adverse scenario
of a 1.2 percent contraction in real gross domestic product
(GDP) proved far more optimistic than the 7 percent contraction
that actually occurred.
"One of the key areas is the nature of the GDP stress, and
how that is dispersed between jurisdictions," said Stephen
Smith, head of KPMG's taskforce on the review of European banks.
One source with knowledge of the scenarios said there was a
case for applying tougher scenarios for countries that had not
yet had major crises, since those nations had further to fall -
an idea that would be contested by countries such as Germany.
"A way of fudging it is to be too generous with growth
forecasts for the periphery," said Colin McLean, chief executive
at Edinburgh-based SVM Asset Management. "(The market will
accept it) as long as the overall GDP assumption is more
stringent than the last time and looks like it's in line with
The last version of the U.S. stress tests set the adverse
scenario for domestic GDP at as much as 4.7 percentage points
worse than the expected scenario for one quarter, though the
average gap was closer to 2 percentage points. The EU tests have
a gap of between 1.5 percentage points and 2.2 percentage points
between the base and the adverse cases.
Analysts view economic growth as the most significant factor
in the stress tests, with KPMG's Smith noting that losses on
banks' mortgages and business loans would be primarily driven by
GDP projections, as well as assumptions around unemployment.
The treatment of others issues, such as government bonds,
will also be important, analysts and bankers said.
The 2011 tests were criticised for not appropriately
measuring the risk of banks' government bond holdings, because
they did not test whether banks could withstand a sovereign
default similar to the one Greece ultimately enacted.
Neil Williamson, head of EMEA credit research at Aberdeen
Asset Management, said another new factor in this year's tests
was the deflationary environment the euro zone could be facing.
Annualised inflation in the euro zone stood at just 0.5
percent in March, its lowest level since 2009, and fears about
deflation - where prices fall - are rife.
Williamson said deflation would hit borrowers' ability to
make loan repayments to banks. New lending would also likely
fall as consumers would be reluctant to borrow to fund the
purchase of an asset that would be cheaper in the future.
"It's clear that deflation is going to be a risk overall at
a macro level, but whether they actually push that far enough
(is unclear) ... I suspect they will focus more on GDP," said
SVM Asset Management's McLean.
In previous stress tests, banks used expected earnings from
activities in emerging markets to cushion the blow of an
imagined recession in Europe. But recent crises engulfing Russia
and Ukraine make this less plausible now, and some banks even
expect to be tested against specific emerging market stresses.
"What's going on in the emerging markets is a real threat to
the developed world," said Moody's Analytics' Zandi. "Many of
the high-flying economies are coming back to earth."
An interest rate test - or how banks would survive if low
interest rates continue to squeeze margins - is another scenario
Aberdeen's Williamson expects to see included.
While the EBA's latest information on the stress tests is
likely to give investors and analysts some insights into how
tough the tests are going to be, it is unlikely to allow them to
draw any conclusions about their likely outcome.
"I strongly doubt we will get enough detail from the
announcement on scenarios for the market to be able to reverse
engineer the tests," said one analyst who asked not to be named.
Working out which banks will pass and fail, and by what
margin, is not everyone's objective anyway. "What we're looking
for is relevance of the scenarios, do they address what we
believe is the risk on the ground?" said Aberdeen's Williamson.
Investor views of those risks have shifted hugely since the
last tests were done, he said, pointing out that investors were
very worried about "tail risk" - or low probability negative
events - back in 2011, but are now so confident in the state of
European banking that they're willing to accept an interest rate
of 4.5 percent from National Bank of Greece.
That begs the question of how much attention investors will
pay to the EBA's findings.
"It's quite staggering how far we've come," Williamson said.
"Investors will increasingly come to ignore these scenarios."
(Editing by Mark Potter)