How Accurate Are the Results of the EU’s Bank Stress Tests?

On July 15, only eight of ninety banks failed a European Banking Authority stress test, amounting to a combined capital shortfall of only 2.5 billion euros. But JPMorgan (NYSE:JPM) analysts say as many as 20 banks need to bolster capital in a report released after the EBA’s results were published, and many analysts are criticizing the test for not being strict enough or testing the right situations. Consequently, the results of the stress tests have failed to allay concerns about default and the government’s ability to bail out lenders.

The EBA test included a 25% writedown on 10-year Greek government bonds held by the banks, though as of July 15, those securities were only trading at 51 cents on the euro. In fact, regulators didn’t even include a Greek default in the test that posed hypothetical situations to banks to test their preparedness, despite the fact that, if one is to take credit default swaps as an indicator, nearly 90% of investors expect a Greek default. By not addressing default or proposing a solution that would protect banks and investors in the case of default, the stress tests largely failed to allay fears that the Greek contagion wouldn’t cause banks throughout Europe to fail, and gave no assurance that the government would be able to bail them out.

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Furthermore, in the past, the stress tests haven’t proven to be accurate examinations of a bank’s health. After passing the EU’s 2010 examinations, Allied Irish Banks (NYSE:AIB) experienced a liquidity shortfall, as did Anglo Irish Bank Corp., which wasn’t even tested, resulting in the EU and International Monetary Fund‘s agreement to give Ireland an 85 billion euro bailout package.

This year, on top of the eight banks failing the tests, sixteen were very close to failing, and will still need to bolster capital in order to protect against the sort of shortfall witnessed in Ireland last year. In total, those 20 banks will have to raise as much as 80 billion euros. And according to EBA Chairman Andrea Enria, about 20 more banks would have failed if they hadn’t raised 50 billion euros between January and April, offsetting the 26.8 billion euros they would have been short in terms of the test.

Banks to Watch: UniCredit SpA (BIT:UCG), BNP Paribas (EPA:BNP), Credit Agricole SA (EPA:ACA), Banco Santander SA (NYSE:STD), Societe Generale (EPA:GLE), Credit Suisse (NYSE:CS), Barclays Plc (NYSE:BCS), Royal Bank of Scotland (NYSE:RBS), EFG Eurobank Ergasias (ATH:EUROB), Deutsche Bank (NYSE:DB), Lloyds Banking Group (LON:LLOY).