LONDON/FRANKFURT European banks must show they can survive simultaneous routs in bonds, property and stocks, in the toughest test so far by regulators aiming to restore confidence in an industry that had to be rescued by taxpayers in the financial crisis.
The European Banking Authority said on Tuesday it would gauge the resilience of 124 banks from the 28-country European Union to see if they would still have enough capital after facing a toxic cocktail of theoretical shocks.
The EU watchdog set out the scenarios which banks such as Deutsche Bank (DBKGn.DE), BNP Paribas (BNPP.PA) and Barclays (BARC.L) could face, in tests whose results will be published in October, raising hopes among some policymakers that banks can finally turn a corner and lend more to the economy.
Previous tests failed to convince markets so that European banks have traded at a discount to U.S. rivals due to doubts over whether they have accurately valued assets on their books.
This time round the European Central Bank is reviewing the balance sheets of the top euro zone banks to ensure the test is based on reliable numbers in the first place.
After the details of the tests emerged the benchmark STOXX Europe 600 banks index .SX7P was up 2.03 percent by 1550 GMT, with almost all the banks in the index rising.
"The scenario is not as severe as it could have been," Fernando de la Mora, Madrid-based head of stress testing at consultancy Alvarez & Marsal, said. "There are certainly countries that could have been stressed more."
De la Mora said countries including Spain, which have already suffered a severe downturn, were exposed to less severe stresses than countries like Britain, France and eastern Europe.
"The granularity and relevance of the scenarios is much better than Europe's first two stress-test attempts, but the absence of widespread deflation is an elephant in the room," Neil Williamson, head of EMEA credit research at Aberdeen Asset Management, said.
"To be fair, deflation in the euro zone would have such dire consequences for both public and private finances, that to include it could have risked too big a jolt to the fledgling confidence returning to the euro zone," Williamson said.
Over a three-year stress test period - a year longer than in the previous exercise - banks must show they can cope with a cumulative loss of 2.1 percent in economic output, much worse than the 0.4 percent decline in the last test.
Such a poor economic performance would push up unemployment to 13 percent and send house prices down 20 percent on average, triggering defaults on loans held by banks, the EBA said.
From a macro-economic point of view, analysts say it is unlikely banks will significantly raise lending until the tests are done, and maybe not even then, depending on what they show.
That has profound implications for the ECB, which has said printing money or quantitative easing is possible if deflation becomes a real threat, something it currently does not expect.
ECB President Mario Draghi has said that quantitative easing remained a way off. The bank tests could be one reason why.
But ECB vice president Vitor Constancio said: "There is no relation between the two things," referring to the tests and quantitative easing.
The ECB is looking at buying corporate assets rather than government bonds, but there is neither the structure nor size of market to make that workable yet. If the ECB did buy government bonds with new money, most of it would flow to the banks, which might then not lend it on, so the impact would be muted.
Data released on Tuesday showed bank lending to euro zone companies and households fell 2.2 percent year-on-year in March.
Constancio said the euro zone largest banks have already taken steps to strengthen balance sheets by an estimated 104 billion euros since July 2013 ahead of the ECB's check-up.
European banks such as UniCredit (CRDI.MI) taking action on capital to avoid the humiliation of failing the tests, and before the ECB becomes their supervisor from November as part of a euro zone banking union.
Banks that fail the test will be given up to nine months to plug capital holes by raising money from investors, scrapping dividends or selling assets.
"Specifying 6-9 months to remedy an assessed capital shortfall significantly constrains the extent to which deleveraging can be used to raise capital," Jason Napier, head of European banks research at Deutsche Bank, said.
Napier said this meant banks were likely to turn to capital markets to fund shortfalls rather than slim down businesses.
Although the European economy is improving after fallout from the financial crisis, regulators opted for their toughest test yet after the failure of each of the previous three exercises to convince markets that banks have enough capital.
The European tests pose a less severe shock than those carried out by the U.S. Federal Reserve, but Europe requires banks to hold a higher proportion of high-quality capital to absorb potential losses in a stressed scenario.
The impact of the theoretical economic slowdown will be felt in six shocks hitting all assets held on banks' trading books, compared with two shocks in the prior test.
This time round banks cannot include planned measures to boost capital after the December 2013 cut-off date for the test.
(Additional reporting by Laura Noonan and Mike Peacock in London, Eva Taylor in Frankfurt; Editing by Mark Potter, David Holmes and Jane Merriman)