Criteria for bank stress tests revealed

Irish banks will have to prove they can withstand another slump in property prices, a surge in unemployment, and sclerotic growth over a three-year period as part of the EU-wide stress tests later this year.

The European Banking Authority (EBA) has unveiled the criteria for the stress tests. They include a 21.2% slump in house prices as well as 14.7% in commercial real-estate prices. Economic output would fall by 2.1% and unemployment would once again creep back up. The banks will also be tested for a sell-off in each country’s sovereign debt.

“The exercise’s full transparency will be key to its credibility,” said Andrea Enria, chairman of the EBA. The stress tests will form a “robust and effective tool for supervisors to address remaining vulnerabilities in the EU”. They will cover 124 banks across the EU.

This is the third set of stress tests carried out on the EU banking system since 2010 by the EBA. The first two were widely seen as lacking in credibility. The criteria laid out for the latest stress tests is an attempt to restore investor confidence in a European banking sector still struggling following the collapse of the financial system in 2008.

The stress tests form part of the ECB’s comprehensive review of the banking system, which will be completed before the Frankfurt-headquartered institution takes over supervision of the eurozone banking system at the end of this year.

A year-long asset-quality review is the other leg of the comprehensive assessment.

Lorcan Roche Kelly of Agenda Research says the asset-quality review has more important implications for the Irish banking system.

If it flags that a bank has insufficient capital, the new bail-in instruments as part of the EU banking union will be deployed.

This will see bank investors, ranking in order from equity investors to junior and senior bondholders and finally uninsured depositors all taking a haircut until any capital shortfall is plugged.

If the stress tests deem that a bank needs more capital, it will be given up to nine months to secure extra funding. Lenders “should start to consider what private sources of capital could be raised as a result of this exercise and plan accordingly”, said ECB vice-president Vitor Constancio.

The EBA exercise, which will cover more than half of each EU member state’s banking industry, is scheduled to begin about the end of May, with results published at the end of October.

It will form the last part of ECB president Mario Draghi’s effort to stamp out lingering doubts about the health of the region’s lenders before his institution becomes the eurozone’s prime bank supervisor.

Additional reporting: Bloomberg