After much discussion and soul-searching – the largest banks in the EU have finally published their stress test results to the European Banking Authority which, in turn, published them to the wider market. When the results were tallied, eight banks failed, and 16 were in the “danger zone” – clearly a mixed bag. It was not, as such, a coincidence that publication was planned for Friday after the markets closed in London.

It’s worth noting that the 2011 EU-wide stress tests were carried out on banks which, in aggregate, represent more than 65% of total assets of the EU banking system, and not less than 50% of the member states of the EU, as measured by terms of their reported positions on December 31, 2010. This takes into account both credit and market risks, in both banking and trading book positions – including off-balance sheet exposures.

One of the major changes in the 2011 stress tests, as compared to 2010 stress tests, is the focus on sovereign risk.  A default by any of the countries within the EU would have enormous consequences.  At the close of trading in London on July 12th 2011, markets indicated that the order of the default, if it occurs, would likely be as follows:

• Greece
  
• Ireland
  
• Portugal
  
• Spain
  

To put this in context, while in the U.S. there is currently debate about the possibility of sovereign default; markets indicate the probability of Greek default is almost six times as high as measured by bond spreads.

One of the areas of controversy in the European Banking Authority (EBA) stress tests is the lack of a liquidity risk component. In 2005 and 2006, this would have remained a small problem.  However, since the implementation of the Basel III Accord, and the requirement for liquidity to prevent the failure of commercial banks, rather than sovereigns, it is notable that there is no specific liquidity risk component included in the most recent tests.

The adverse scenario required to be tested for is more severe than the 2010 exercise in terms of deviation from the baseline forecast and the likelihood that it materializes. It includes a marked deterioration in the main macro-economic variables, such as GDP, unemployment, and home prices.

The adverse scenario also includes a specific sovereign stress in the EU, leading to further declines in the price of some EU bonds from the already stressed levels seen at the end 2010. The sovereign haircuts will apply to positions in the trading book where losses would materialize and will be accompanied by full disclosure of all relevant sovereign holdings.

Prior to the announcement of the financial sector stress test results, finance ministers from the 27 EU member states indicated a willingness to stand behind banks that fail the tests, taking a proactive approach to put in place strategic action plans for the provision of government support, to aid failing banks in accordance with state aid rules.  Markets will now await their action.

The results of the most recent stress tests make it clear that there is both opportunity for investment as the need for greater visibility is reinforced and cause for concern as sovereign debt yields continue to rise. These tests also present a new challenge for regulators, as there may now be grounds for suggesting that Basel III disclosures be updated to include adverse scenario stresses and a number of data items from the Internal Capital Adequacy Assessment Process (ICAAP).  One absolute certainty for banks in Europe…and their U.S. counterparts…is that a new era of stress testing rigor has, indeed, arrived.

This blog was contributed by John Christiansen, a senior director of sales consulting for Oracle Financial Services Analytical Applications.