Documents released by the new banking watchdog of Europe shows that it is preparing tough fitness tests for the regions banks so that they can withstand future shock losses in the event of crises.
The European Banking Authority (EBA) has started stress test – a standard procedure to measure a bank’s ability to absorb losses, on the regions 88 banks holding the region’s 65 percent assets to check the bank’s preparation to face severe economic crises.
The stress test formulated by the EBA will measure the bank’s solvency (long-term liquidity) against a baseline case and an adverse macroeconomic scenario. Under the adverse scenario, it will focus mainly on financial markets.
“This adverse scenario is similar to those developed for EU-wide stress tests in 2009 and 2010, EBA wrote in a note sent to banks to prepare for the test.
“It is composed of three elements: a set of EU shocks, mostly tied to the persistence of the ongoing sovereign debt crisis, a global negative demand shock originating in the U.S. and a U.S. dollar depreciation vis-a-vis all currencies”, the note said.
The current year’s assessment will help restore confidence among investors in a segment which depends upon government bail-outs in many EU member countries. The EBA was established in January and has the authority to impose binding standards among member countries.
The European Central Bank (ECB), which designed the adverse scenario – has included a 15 percent drop in share prices in the European markets along with 0.5% contraction in the region’s economy. The scenario also takes into consideration a crash in the real-estate market prices and a 75 basis points decline in long-term Eurozone bond yields. A 125 basis point jump in the wholesale market for short-term interbank lending rates has also been included.
The wide ranging scenario analysis exercise will study the effect of the Eurozone economy contracting by another 0.2%. Demand shocks emanating from the US markets, including a 4 percent depreciation of US dollars will also be considered.