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EU banks required to disclose sovereign exposure

Anti-austerity protests in Athens
Image caption Many analysts expect Greece to have to restructure its debts once bail-out loans expire from 2013

Europe's biggest banks must fully disclose exposures to sovereign debts.

The requirement has been stipulated by the European Banking Authority (EBA) as part of a new round of stress tests.

However, banks will not have to consider the impact of a formal default by a European government - a key criticism of the previous tests that failed to anticipate the collapse of Irish banks last year.

Nonetheless, the EBA said the latest tests will be much stricter.

The new tests will run for the next three months, with the results to be published in June this year.

Sovereign shock

Banks will be "expected to disclose their exposures to sovereigns broken down by accounting portfolios, maturities and countries," said the newly created banking regulator for the European Union (EU) in publishing the test methodology.

The disclosure will make it easier for market analysts to assess the ability of the banks being reviewed to withstand an EU government debt restructuring - something that many analysts expect to happen once current bail-out loans expire in 2013.

Greece and the Republic of Ireland have already received financial rescue packages from European peers and the International Monetary Fund, with Portugal widely expected to join their ranks in the coming months.

Image caption Investors have concerns about Spain's finances after the country suffered a collapse of its property market

Investors have also expressed doubts about Spain's finances, after the country suffered a property market collapse and its unemployment rate rose to more than 20%.

On Thursday, the Spanish central bank revealed that the proportion of bad loans in the country's banking sector hit a 16-year high in January.

Spanish lenders were sitting on 110.7bn euros (£97bn, $156bn) of bad debts, equal to 6.1% of all banking assets and 11% of Spain's annual economic output.

'Adverse scenario'

The new regulatory tests will cover lenders that hold over 60% of all EU banking assets.

It is unclear which banks will be included. Last time 91 banks were involved, and recently leaked documents suggest the number will be 88 this time round.

The tests will also include their own "sovereign shock" scenario, as was the case in the previous round held in 2010.

The scenario will involve cutting the market value of the bonds of countries such as Greece, Portugal and Spain by much more than the lows seen late last year.

However, by excluding a formal default from its analysis, it means that banks will not need to write down the value of the government bonds they hold for the long term.

In the "adverse scenario" of the tests, the current growth forecasts for the EU will be lowered by four percentage points, meaning the economy would shrink by 0.4% in 2011 and experience zero growth in 2012.

That compares with only a three percentage-point growth shock applied in the previous tests.

The new test will also apply bigger stresses of unemployment levels and housing prices across the EU.

Lower house prices would force banks to cut the value of mortgages in their balance sheets.

Consistency

The previous round of tests - which was run by the EBA's predecessor, a supervisory board composed of national regulators - was also accused of being applied inconsistently across different EU members.

The newly-created banking regulator hopes to address this criticism by imposing a common and more restrictive definition of "core tier one capital" - the cushion that regulators require banks to maintain to absorb losses on their loans and investments.

However, the EBA has yet to say how high it will set the minimum capital ratio this time.

Previously the hurdle was set at 6% of a bank's assets.

But whatever it is set at, the supranational regulator has already said that even if a bank just manages to scrape a pass, it may still be required to top up its capital reserves.

The EBA will also insist that the banks use the balance sheets they reported in their accounts at the end of 2010 for the test.

This will avoid the possibility of banks cheating by temporarily shifting exposures off their balance sheet for the duration of the tests.

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