Q&A: What are the European bank stress tests for?

ECB head Jean-Claude Trichet knows all about it

After weeks of anticipation and speculation, the results of the European bank stress tests have finally been announced.

Seven of the 91 banks tested have failed, according to the Committee of European Banking Supervisors (CEBS).

They include five Spanish banks (Diada, Espiga, Banca Civica, Unnim and Cajasur), one German bank (Hypo Real Estate) and one Greek bank (ATEBank).

The month-long examination of Europe's biggest banks had been murky, with leaks and rumours, but few official announcements.

Nominally, it was run by CEBS but the reality was a typically messy compromise among the 27 European governments.

Some have argued that the entire process was unnecessary, because the crisis had already passed.

So what are these tests, what are they for and what happens next?

Why is this happening?

The eurozone suffered a major crisis in recent months, amid speculation that Greece was unable to repay its debts.

While Greece has been given a reprieve with a 110bn-euro rescue package from the EU and IMF, concerns still linger over the health of the European banking system, with many banks dependent on the European Central Bank (ECB) for financing.

Markets have two basic worries: that European banks are not strong enough to withstand a second recession and that many have large exposures to Greece, Portugal and other governments that might default on their debts.

The EU devised the stress tests in order to identify which European banks - if any - are dangerously vulnerable and need to be strengthened, or even taken over.

European governments hope that by doing this, they can restore international confidence in their banks, which is essential for them to help finance the economic recovery.

What is a stress test?

Regulators wanted to know whether a bank would survive an extreme scenario, such as a double-dip recession, without going bust.

They did this by making assumptions about how different types of assets (loans, etc) owned by the banks might fall in value.

So, for example, if regulators want to look at a scenario in which house prices fall by half, they would slash the value of all of the mortgages lent out by the bank by a corresponding amount.

If the losses would be so great that they wipe out all of the bank's capital, then the bank would become insolvent in this scenario.

This means the bank has failed the test and will be required by the regulator to increase its capital - for example, by issuing new shares.

What is bank capital?

A bank can get money from one of two places - borrowing (which includes money "lent" to it by ordinary depositors) and capital.

Unlike borrowing, capital is money that the bank is not legally obliged to repay to investors. It includes ordinary shares in the bank.

The bank's capital acts as a cushion to absorb losses on the loans it makes.

If a loan goes bad, the bank writes down the value of its capital by the amount of the loss, meaning that its shareholders and other capital investors take all of that loss.

However, if losses are so big that the bank's capital is written down to zero, then it means that the bank is insolvent - in other words, the value of the bank's loans and other assets is no longer enough to repay all of its borrowings.

Which banks were tested?

The original plan was only to look at the very biggest European banks.

But regulators expanded the list to a total of 91 after worries were raised over some medium-sized banks in Spain and elsewhere.

Collectively, these 91 banks represent 65% of the European Union's banking sector.

The number and size of the banks varies from country to country, but must together represent at least 50% of each country's banking sector.

In the UK, the big four banks - HSBC, Royal Bank of Scotland, Lloyds and Barclays - were examined.

In other countries, smaller institutions that are still deemed to be of systemic importance were also included.

For example, in Spain a total of 27 banks were looked at, including all of the cajas (savings banks), which have large exposures to the collapsed Spanish property market.

The Spanish list also included banking giant Banco Santander, which owns Abbey, Bradford & Bingley and the Alliance & Leicester in the UK.

In Germany, the Landesbanks (state-owned regional banks) were of particular concern.

What scenarios were looked at?

Three different scenarios were looked at:

• a "baseline" scenario that assumes a continuing recovery

• an "adverse" scenario, assuming a two-year double-dip recession

• an "additional sovereign shock" on the adverse scenario, which includes some kind of financial crisis for European governments such as Greece, as well as the double-dip recession

The sovereign shock involved a hypothetical fall of about 25% in the value of relevant government bonds.

Significantly however, banks may still be allowed to value these bonds at 100% if they say that they intend to hold the bonds until they mature.

In order to pass the test, banks had to maintain "tier one" capital - the strictest measure of capital - equal to at least 6% of their assets (which are reweighted for this purpose according to their riskiness).

There are market concerns that the sovereign shock test may not have been extreme enough.

Some investors think that a worst-case scenario could see Greece and several other European countries default on their debts and possibly also exit the eurozone.

Who decided the tests?

The tests were co-ordinated across the European Union, which set the overall parameters of the tests.

However, the actual testing was done by the national banking regulator in each country - meaning the Financial Services Authority in the case of the UK.

The exact details of each scenario are not yet clear, and individual national regulators may have varied them when they came to test their own country's banks.

This has led to market concerns that the test results may not be comparable across different European countries, and some national regulators may have gone too easy on their banks.