Euro banks fail the stress test

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Bankers were crowing at the end of October when it was revealed that “only” 25 Eurozone banks failed stress tests conducted by the European Central Bank (ECB).

The tests, which looked at how banks would cope with adverse economic conditions, highlighted particular problems for the troubled Italian economy, where nine banks failed, but gave the all clear to much of the sector across Europe.

There are, however, questions about the stringency of the tests, especially as earlier tests, in 2011, cleared banks in Belgium and Ireland months before they had to be bailed out.

There are two problems with last month’s tests. First, they allowed banks a degree of flexibility in valuing their assets. With this approach, French banks had no capital shortfall. A different test, performed by US academics, found that, if different assumptions were applied including valuing assets at market prices, there was a £149 billion shortfall.

Worse, the stress tests did not examine what would happen if the Eurozone entered a period of deflation — which increases the weight of debt. Deflation is already under way in Italy, Spain, Belgium, Portugal, Greece and Poland.

Despite the hype about the recovery, Europe’s banking sector is not out of the mire yet.