Europe's banks are still waiting for a complete stress test. Details released on Oct. 3 show how the European Banking Authority's benchmarking exercise last December did a more robust job than previous bank tests, which had not properly stressed for a euro zone sovereign default. But there's still huge room for improvement.
The EBA's latest test used sovereign haircuts based on the gapped-out bond spreads seen almost exactly a year ago, then required banks to achieve a 9 per cent core Tier 1 ratio. By the end of June, the 71 banks tested had raised over €200-billion of new capital. Yet investors are unlikely to relax.
For one thing, the EBA didn't test for the losses a recession would bring. For another, the exercise was based on a so-called Basel 2.5 basis, an easier hurdle to jump than new Basel III rules. If Basel III was adopted right now and banks had to hold at least a 7 per cent core Tier 1 ratio, they would need to find an additional €224-billion compared to the banks' position in December, according to the EBA's recent analysis of 156 European banks.
But the biggest problem with the EBA's methodology is that the banks used their own models – always opaque and quite possibly incautious – to measure risk-weighted assets, the denominator in the calculation of capital adequacy. The Basel Committee questioned the validity of these on Monday and the European Commission's advisory Liikanen committee complained about inconsistency on Tuesday.
The EBA can do better. It should base the next stress test, planned for the second half of 2013, on Basel III inputs, throw in credible macroeconomic stresses and use a common standard for risk-weighting. The Basel Committee, not the banks, should set the risk-weighting rules.
Up to now, national regulators have successfully resisted pressure for impartial pan-euro zone weightings. Those objections never made economic sense, but they should now also be practically irrelevant, since the regional European Stability Mechanism is standing by to recapitalise banks and banking union is on the horizon. The EBA has no more excuses not to be tough.