It is billed as a moment of truth — but some fear an exercise in obfuscation. The results of European Union stress tests designed to uncover the depth of rot in the continent's banking system come out later this week — and an accurate reading would go far to answer the key question of whether Europe's debt crisis is finally over.
Some experts expect gloom whatever the result: Bad news could send markets into a tailspin again.
Too rosy a picture, on the other hand, may alarm investors that the tests have not been rigorous enough.
The hope is that the results are credible enough to lift the cloud of uncertainty surrounding the exposure of European banks to the debt crisis. U.S. stress tests last year helped to shore up confidence after 10 of 19 banks failed tests and were told they needed to raise around $75 billion.
Europe's debt crisis has already forced Greece to take a 110 billion euro ($142.43 billion) international bailout to avoid bankruptcy, and pushed governments to put up a $1 trillion backstop for troubled governments if they need it. Greece's near-failure sent shivers of fear through investors wondering which banks' balance sheets were hiding Greek and other debt that could go bad.
Most of the 91 banks tested are expected to pass — but analysts say some must fail for the tests to have any credibility. And failure won't necessarily mean the banks are bust, but that they will need to raise money from investors or governments.
Raising more money will be an unpleasant reality that should not be dodged, said Nicolas Veron, a senior fellow at economic think-tank Bruegel in Brussels.
"If its outcome is to be credible, it will necessarily reveal significant capital shortfalls in a number of banks," said Veron. Analyst estimates range from 50 billion euros to 100 billion euros for new capital requirements.
Those perceived to be candidates for fresh capital injections when the tests are revealed after market close Friday afternoon are some of the smaller Spanish banks — the so-called cajas — hit by the real estate collapse, and regional German banks —the Landesbanken — that made oversized bets on global financial markets before the 2008 meltdown. Both cajas and the Landesbanken are not listed on stock markets and thus not subject to analyst scrutiny the way major banks such as Germany's Deutsche Bank, Britain's Barclays and France's BNP Paribas are.
Equally important will be the response from policymakers and the banks themselves, and the window for action may only last until traders return to their desks Monday morning.
"The announcement of the results needs to include a clear and detailed recapitalization plan for those banks or national banking systems that did not prove resilient to the stress tests," said Silvio Peruzzo, euro area economist at the Royal Bank of Scotland.
Despite the intense market focus on the tests, little is actually known about how the London-based Committee of European Banking Supervisors (CEBS) is conducting its analysis — in marked contrast to the tests that were undertaken last year in the U.S.
What is known is that the CEBS's "adverse economic scenario" assumes that the EU economy underperforms the EU Commission's forecasts by three percentage points of gross domestic output — in other words, a recession. In May, the Commission predicted that the EU economy would grow by 1 percent this year and 1.7 percent in 2011.
The key unknown is what potential losses the CEBS assumes banks will have to absorb from losses on their investments in government debt — Greek bonds, widely considered the most risky, are expected to have a "haircut" of around 20 percent, while the discount for Germany is likely to be in the very low single-digits at most.
If the probability attached to a Greek debt default is too low, for example, then investors may dismiss the results and continue to worry about hidden losses. Equally, if the tests are too tough then investors will fret about how the banks will be able to raise the money to rebuild their capital.
"Stress testing is a gamble," said Ken Wattret, chief eurozone economist at BNP Paribas.
The euro will likely bear the initial market reaction — the results will be released after Europe's bond and stock markets close on Friday, but New York will still be open.
The euro has advanced over 10 cents since hitting a four-year low of $1.1878 in early June on a combination of easing worries over Europe's sovereign debt crisis and concerns about the U.S. economic recovery. On Friday, the euro broke above the $1.30 mark for the first time since early May.
Neil Mackinnon, global macro strategist at VTB Capital, thinks the tests will be anything but "stressful" and, given the positive noises coming from many European capitals, increasingly look like they are going to be a "whitewash."
Mackinnon pointed out that the 20 percent figure for the Greek 'haircut' is way too low. Something nearer 50 percent would be more realistic, he said.
"There is every likelihood that these tests will not be stressful at all, which will leave financial markets suspicious that policymakers and regulators are not engaging in a transparent and honest assessment of banks' true balance sheet positions, especially with regard to sovereign risk exposure," said Mackinnon.
Several of Germany's Landesbanken stumbled during the financial crisis and had to seek help after making big bets on global financial markets and large investments in shaky bonds backed by U.S. mortgages to people with poor credit.
German Finance Minister Wolfgang Schaeuble has said Germany should be able to handle any signs of stress "with the instruments we gave ourselves in the banking crisis" in 2008. There is no serious talk of bank mergers resulting in Germany from the tests, although there has been talk for years of the need to consolidate the Landesbanken.
Germany's financial-sector rescue fund started out with a maximum 80 billion euros to recapitalize banks and 400 billion euros in loan guarantees. It has more than half of that left: some 50 billion euros for capital injections and 247 billion euros in guarantees.
Much of the attention Friday will likely focus on the Spanish banks, and the cajas in particular, which have been heavily exposed to the collapsed real estate sector in the country. The CEBS is assessing the fortunes of 27 Spanish financial institutions— making Spain the country with the most banks under scrutiny.
Other question marks include Austrian banks' 204 billion euros in exposure to central, eastern and southeastern European debt. The country's central bank says those exposures are well diversified and mostly locally financed, diminishing risks of a cash crunch.
Banks in France have significant exposure to Greek debt, but France's Finance Minister Christine Lagarde says she's not "worried" about their performance in the stress test.
Analysts expect Swedish banks, despite high exposure to debt in the Baltic countries where the recession has been severe, to pass the stress tests thanks to writedowns and other steps already taken.
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