Will growth save Europe's banks?

BBC business editor Robert Peston on the European banks' stress tests

The results of tonight's stress tests on Europe's banks would be less momentous if economic growth in the European Union is reinforced.

The widespread concerns that the tests simply aren't severe enough would not matter so much if the stresses that banks will actually face over the next two years or so turn out to be fairly mild.

Think of it as the equivalent of testing the robustness and integrity of an aeroplane. The prudent thing to do is recreate the conditions of a Force 10 gale or worse and see if the plane stays in the sky in such hideous conditions.

But if, in the engineering test, all that's simulated is a Force 5 gale, that wouldn't matter quite so much if in practice the relevant plane were never to fly through anything windier than that.

Which is why for banks' creditors and investors, yesterday's news that manufacturing and services output in the EU - and especially in Germany - appeared to be growing faster than expected, well that was encouraging.

The Purchasing Managers Indices indicated that EU growth may be picking up a bit of momentum. Which might mean that over the next year or two, the worst that confronts the banks will be a Force 5 gale, rather than a tornado.

But here's the thing: most of us wouldn't chose to fly in a plane that couldn't prove its ability to remain airborne through a tornado. And, over time, creditors, depositors and investors will shun banks that have insufficient capital and liquid resources to withstand substantial financial shocks.

That's why it's not just the results of the stress tests that matter, the publication of which banks have failed and need to raise capital: all the indications from governments, regulators and banks are that there won't be many of those.

So as important as the test results will be the new details provided tonight by Europe's banking regulators on the calibration of the adverse financial and economic conditions that the banks would have to endure.

As I've mentioned before, there are reasons to believe that the simulated macro-economic scenarios and the translation of those scenarios into loan and investment losses simply aren't severe or demanding enough.

Banks have had to prove that they can cope with a comparatively mild recession, with falls in government bond prices of up to 25% (in the case of Greece) but not default by governments, and with losses when other creditors default that are less than for the UK's equivalent stress tests.

What's more, two other arguable flaws in the tests are the Basel II definition of capital employed in the tests and the minimum ratio of capital to assets that banks have to prove they can preserve (see my note, Eurozone: Stressful 'haircuts' for why a 6% Tier 1 ratio under the Basel ll definition would allow some banks to disguise their intrinsic frailty).

Probably the best that can be said of the stress tests is that at least we should have a lot more information about the risks being run by Europe's biggest banks.

Transparency is almost always a good thing. But if the perception were to take hold that banks' weaknesses had been revealed but not corrected, that could undermine the confidence of creditors and investors in Europe's banks.

So what do investors and creditors actually expect the tests to reveal?

Well, Goldman Sachs has just published a fascinating survey of their views on the tests.

Here are the results: 10 of the 91 banks won't pass the test; just under 40bn euros of new capital will be raised, with roughly half being provided by taxpayers; and banks in Spain, Germany and Greece are expected to raise the most capital (d'oh!).

Perhaps more tellingly, some 37% of the 376 big investors who were polled fear that even after the stress tests and capital-raisings, European banks will still have too little capital.

That carries a slightly nerve wracking implication for European banks and regulators - which is that if fewer than 10 banks flunk the tests, and if the banks are obliged to raise significantly less capital than 40bn euros, there's a danger that investors will regard the tests as lacking credibility.

If the tests are perceived to lack credibility, they'll have solved very little, in that some European banks would continue to find it difficult to borrow from other banks and financial institutions - and the history of the past three years (and the history of the last few hundred years) shows that can be a precursor to meltdown.

You can keep up with the latest from business editor Robert Peston by visiting his blog on the BBC News website.

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