European banks are mostly endangered today because of the sovereign risk – the risk that an EU Member State might default. The banks have bought lots of government bonds from different EU governments, and now we want to know how much capital they need in order to stay solvent. That is why we need to conduct bank stress tests.
A bank stress test is intended to give an overview of the possible bank performance in case some serious risk materializes. This risk is called a “stress scenario”, and banks calculate if they’ve got the capital reserves to cover losses.
There is news that the results of ongoing tests on European banks will be published on 23 July. Markets need those results in order to get the real snapshot of the EU financial system, and to calculate the risks and perspectives for the EU economy.
But the stress tests results must be useful and transparent if they are to calm the markets. One of the issues is to include all systemically important banks. But the stress tests must also include really worst-case scenarios, as Wolfgang Münchau has argued. Designing stress tests in such a way that the banks will pass them will not convince the markets. Additionally, the stress tests results must be published in full – guaranteeing the transparency of the procedure.
The stress tests are probably the only tool we now have to convince financial markets that EU banks are stable. That is why any improvisation should be avoided.