Ease up on Europe’s banks or more will fail tests

EUROPE’S bank stress tests need a higher pass mark. Last year’s flop demanded that lenders only need 6% Tier 1 capital in a stressed scenario — a hurdle that all but a handful were able to clear.

To make the latest test more credible, regulators should ideally switch to core Tier 1 capital. If that’s not possible, they should raise the bar.

Regulators are making some improvements. The draft scenario for the tests — sent to lenders on March 4 — assumes a bigger economic contraction than in previous years.

It also spells out larger drops in property prices, with those countries that enjoyed the biggest boom suffering the heaviest falls.

There are still some familiar flaws, particularly relating to the treatment of government bonds.

Once again, regulators have shied away from assuming a sovereign default in the eurozone.

As a result, government bonds held in so-called “banking books” — the vast majority — do not suffer a haircut. The best investors can hope for is that, like last year, banks will be forced to publish their exposures.

The key question, however, is what the pass rate for the tests will be. Ideally, regulators would ditch the discredited Tier 1 measure of capital — which includes hybrid debt — in favour of core Tier 1 capital, which provides a better estimate of a bank’s ability to absorb future losses.

Regulators argue there is currently no agreed definition of core Tier 1 capital. But if they insist on sticking with Tier 1, the other way to improve credibility is by raising the bar.

Last year, a 6% Tier 1 hurdle meant that only seven small lenders failed the test. If the hurdle had been 8%, a further 32 banks would have been forced to raise capital, according to Morgan Stanley.

Some of these have raised capital since, but imposing a higher pass mark would give the tests more credibility. It might also prompt those European countries with the weakest lenders — notably Germany and Spain — to take more urgent steps to shore up their banks.

That would reduce the risk that zombie lenders will continue to act as a drag on the region’seconomy.