April 8, 2011 / 8:31 AM / 8 years ago

EU banks must have 5 percent quality capital to pass exam

LONDON (Reuters) - Europe’s banks must prove they hold more than 5 percent of high-quality capital in order to pass a test aimed at reassuring taxpayers they can withstand future recessions.

German Commerzbank headquarters are pictured through a mirrored artwork ahead of the Commerzbank annual news conference in Frankfurt, February 23, 2011. REUTERS/Alex Domanski

The European Banking Authority (EBA) on Friday named 90 banks which must undergo the so-called “stress test” in an attempt to repair the sector’s image after massive bailouts.

It will decide how many need to raise capital, sell assets or shrink their loan book to make them strong enough to withstand economic headwinds.

The EBA is keen to be seen as tough after last year’s health check flopped and will use a definition of capital that is more stringent than last year.

The 5 percent pass mark for core Tier 1 capital is comparable to the standard set for U.S. banks under their recent exam, the EBA said.

The U.S. results were released to the banks last month but not made public. Banks that came through strongly were allowed to bump up dividends or buy back shares. In contrast, European banks are being encouraged to keep conserving capital.

Europe’s regulator, running the stress tests for a third time since the financial crisis unfolded, will exclude much of a hybrid debt-equity type of capital used by many German state-owned banks and seen as a controversial issue.

The results will be released in June.

The exercise aims to draw a line under the bloc’s banking problems and is already having an impact.

Banks are bolstering their capital ahead of the test. Even though few are expected to fail, being close to failing could prompt weak banks to raise capital. 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 bolster their capital levels.

Banks that fail, or some that only narrowly pass, are expected to work with national regulators to fix the problem.

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.

BORDERLINE BANKS

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.

Few banks will fail the test, but lenders seen in the “near pass” region are already under pressure to raise cash or see their shares discounted in comparison to rivals who have built more robust capital levels.

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.

The EBA said it has set the most consistent definition of core Tier 1 capital possible — given it varies among countries — that mainly comprises common equity and retained earnings.

To qualify, capital must be simple and readily available. The definition strips out complex forms, though capital injected by governments is acceptable.

Some of German banks’ “silent participations” issued during the financial crisis will be allowed, but those issued before the crisis will not. This debt-equity hybrid is used widely in Germany, but 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 signaled it will convert its pre-crisis silent participations to improve its capital position.

The “stress” situation applied by the test includes economic slowdown, rising unemployment, tumbling property prices and a drop in stock markets.

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.

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.

Additional reporting by John O'Donnell in Budapest and Edward Taylor and Alexander Huebner in Frankfurt; Editing by Sophie Walker

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