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Europe is set to unleash rigorous U.S.-style stress tests on its battered banks, an effort designed to prevent a repeat of the banking crisis that paralyzed the global financial system less than two years ago.

The new tests, announced by European Union officials earlier this week, will be much broader and more intensive that last year's tests, which were widely viewed as ineffective. They are coming after a two-month slide in bank shares triggered fears that the banks would get chewed up by the sovereign debt crisis and government austerity programs. Many European banks have shed 20 per cent of their market capitalization since April and a few major institutions, such as France's Société Générale SA and Spain's BBVA, have lost one-third of their value this year.

In 2009, European governments tested the financial health of about 25 big, cross-border banks. Only aggregate results were disclosed, and those results were not used to force the banks to raise new capital. The new version will put as many as 120 banks under the financial microscope; the results are to be put on public display late this month.

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Crucially, the new tests will determine whether the banks could cope with a sovereign debt default within the euro zone. While EU officials did not specifically mention Greece in the draft mandate on stress tests, there is no doubt the banks' exposure to Greek bonds, as well as those of Portugal and Spain, will be tallied up.

The stress tests will be positive in the sense that they will create a level playing field for everyone," he said. "It will show which banks are undercapitalized and force them to raise capital. Georg Thilenius of Dr. Thilenius Management

The national governments administering the tests say they will ensure that banks with inadequate capital cushions will receive, or be forced to raise, more capital.

The decision marks a key moment in the fight to contain a debt crisis that has spread through Europe this year. Stress tests done last year in the United States were credited with turning around its crippled banking sector, allowing them to raise capital and stabilize the banking system. Ten of the largest lenders, including Bank of America, Wells Fargo and General Motors Acceptance Corp., were instructed to raise tens of billions of dollars. The capital-raising effort helped to restore investor confidence in the banking system; bank shares soared. As a result, the country's recession probably ended somewhat sooner that it would have without the tests.

Rob Wessel, managing partner of Hamilton Capital Partners, a Canadian investment firm whose funds invest in North American financial services stocks, said the new European stress tests aim to achieve the same success and could mark a turning point for the European financial sector. "There is no question this worked in the U.S.," he said. "Getting more visibility and capital into the European banking system is critical."

Georg Thilenius of Dr. Thilenius Management, a fund manager in Stuttgart, Germany, has a similar view. "The stress tests will be positive in the sense that they will create a level playing field for everyone," he said. "It will show which banks are undercapitalized and force them to raise capital."

Stress tests will be conducted by national banking regulators and co-ordinated by the Committee of European Banking Supervisors, which advises the European Commission on banking matters and promotes EU banking stability. The banks are, among other things, tested on their so-called Tier 1 capital - a ratio of capital to assets that is a key measure of financial strength. The European Central Bank wants to see the ratio at 6 per cent or more, even though the legal minimum is 4 per cent.

The European stress tests may produce unpleasant findings, even though some of the big banks have significantly boosted their Tier 1 ratios (Deutsche Bank's, for example, is 11 per cent). In its annual report, published Monday, the Bank for International Settlements (BIS) warned that banks remain "highly leveraged and still appear to be on life support. The essential task of reducing leverage and repairing balance sheets is simply not finished ... Losses on European bank balance sheets are expected to mount over the next few years."

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Most of the biggest euro zone banks, especially those in Germany, France, Italy and Austria, appear to be in fairly good shape. The stress tests, however, are bound to show that many of the smaller banks are in trouble, notably those in Germany and Spain.

In the euro zone, it is the German banks that are most exposed to dud loans. A new study by PricewaterhouseCoopers said that some €213-billion ($282-billion) of non-performing loans sat on the balance sheets of Germany's banks in 2009, up 50 per cent from the previous year. Many of soured loans were made to the real estate sectors in Greece and Spain, where property prices have plunged and unemployment has soared. Analysts expect some of the smaller German banks to merge after the stress tests are published.

Spain's 45 regional savings banks, known as cajas, are heavily exposed to the gutted Spanish real estate market and are under pressure from the Spanish central bank to merge and clean up their balance sheets. The bank on Tuesday said that 39 of the cajas are involved in mergers. The central bank has set aside a €12-billion fund to restructure the savings banks. The amount can be leveraged up to €99-billion, if necessary.

An Italian newspaper report said the stress tests will reveal that Italy's banks will need €25-billion in fresh capital, even though they held up relatively well during the financial crisis. But Mario Draghi, the head of the Bank of Italy, dismissed the report as fiction. "I am amazed by the speed and fantasy of who comes up with such numbers," he said.

Bank shares have climbed in recent days as the expectation that the European stress tests will help clean up the banking mess. They also got a boost from the news that the ECB on Wednesday lent banks €132-billion for three months, less than the €200-billion in life support that analysts had expected.

Still, some investors are wary. Mr. Thilenius, who says his funds made a lot of money on last year's bank rebound, is sitting on the sidelines. He's worried that the European budget deficit crisis and the effort to tax banks to fund future rescues will weigh on the sector in the next few months.

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About the Author
European Columnist

Eric Reguly is the European columnist for The Globe and Mail and is based in Rome. Since 2007, when he moved to Europe, he has primarily covered economic and financial stories, ranging from the euro zone crisis and the bank bailouts to the rise and fall of Russia's oligarchs and the merger of Fiat and Chrysler. More

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