Credible EU bank tests need a higher pass mark

Europe’s banks may need to re-sit their summer exam. Regulators are looking for ways to inject more capital into the region’s troubled lenders. One potential quick fix is to use the same data as in July’s discredited stress tests, but impose haircuts on sovereign debt. But this wouldn’t be enough. The authorities should also raise the minimum capital ratio that banks need to clear.

The flaw in July’s tests was that banks did not have to mark down the government bonds they currently hold at face value. As a result, only eight of the EU’s 90 largest lenders flunked the exam, with a capital shortfall of just 2.5 billion euros. Since then, worries about sovereign debt have spread from Greece and Portugal to Spain and Italy, threatening a systemic crisis.

Ideally, regulators would conduct another test. But that would take months, and Europe does not have the luxury of time. An alternative is to re-run the tests with the same data, while forcing the banks to mark all sovereign bonds to current market prices.

In that scenario, 18 banks would fail, with a capital hole of 40 billion euros, according to Breakingviews’ stress test calculator. But that would not be enough to restore confidence. The International Monetary Fund puts the capital shortfall of European banks at between 100 billion and 200 billion euros. Some analysts have come up with even higher numbers.

To address these concerns, regulators should simultaneously raise the minimum core Tier 1 capital ratio that banks need to clear. July’s tests set the hurdle at 5 percent, which now looks too low. If it was raised to 7 percent, more than half the 90 banks involved in the tests would need a combined 98 billion euros of extra capital.

This beefed-up exam would raise problems. The United Kingdom, which was part of the stress tests but is less affected by euro zone woes, might refuse to join in. But as a quick way to restore confidence in Europe’s banking system, re-sitting a tougher exam might be worth a try.

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