Minimum bank capital ratio set at 5.5 percent in European stress tests

The European Banking Authority (EBA) on Friday announced details of the stress tests to which 124 of the biggest banks in Europe – including 16 Spanish lenders – will be subjected to later this year.

The banks will have to show that their highest-quality capital ratio will not fall below 5.5 percent in a severe economic crisis. The European Central Bank had made it known that the minimum capital ratio would be set at around 6 percent. For normal circumstances the limit has been set at 8 percent of risk-weighted assets.

The tests will evaluate credit risk, market risk, sovereign risk, securitization and the cost of funding. Both trading and banking book assets will be examined, including off-balance sheet exposure.

The resilience of EU banks will be assessed under a period of three years (2014-2016). The tests will be carried out in close cooperation between the EBA, the ECB and national central banks. The methodology and scenarios are expected to be published in April 2014, while banks’ individual results will be released at the end of October. Banks failing the test may be obliged to raise capital to improve their level of solvency.

Earlier stress tests carried out under the auspices of the EBA failed to convince the markets, which put a lot of pressure on banks, particularly in Spain, because of concerns about their exposure to risky assets. In the case of countries such as Spain and Italy, of particular concern will be their exposure to sovereign debt, which accounts for about 10 percent of their assets.

Spanish banks have resorted to what is known as a carry trade in which they borrow from the ECB at rates close to zero percent and invest in 10-year Spanish government bonds offering a yield of 4 percent. The EBA and the ECB will measure the level of resistance of these bond portfolios.

Spain's banks in December picked up the pace at which they have been offloading their holdings of sovereign debt ahead of the stress tests. Taking advantage of improved market conditions, they sold 22.4 billion euros’ worth of government bonds in December, more than double the 10 billion they sold in November and October’s 8.9 billion. As a result, their exposure to sovereign debt stood at 272 billion euros at the end of last year.

The ECB and the EBA, as well as other European institutions and national governments, have insisted on the need for the test to be rigorous enough to dispel doubts. EBA sources said Friday the tests “are stricter than those used by the United States” at the start of the financial crisis.