EU begins bank stress tests with rules still unclear

Chancellor Merkel wants private creditors - including banks - to take losses in future government bail-outs

The EU has begun a new round of stress tests of its banks.

The process, led by the new European Banking Authority, will last months with results not due until June.

It follows the failure of previous tests to unearth problems at Irish banks that later had to be rescued.

Although the latest examination of banks' balance sheets is supposed to be much stricter, regulators have yet to agree a methodology, including whether to consider a government debt default.

Broad principles for the bank tests will not be published until April.

'Not the final word'

"If the methodology for this round of tests is not significantly different to the last set, it will seriously hinder reliance on these tests," noted business analytics firm SAS.

A key criticism of the previous stress tests was their failure to include a formal debt default by a European government.

This would require banks to write down the value of government bonds that they hold for the long term in their "banking book", potentially rendering some of them insolvent.

Some market participants expect Greece, the Irish Republic and other EU countries to have to restructure their debts when existing rescue facilities expire in the next few years, forcing lenders and bondholders to take losses.

But most national banking regulators at a meeting on Wednesday still wanted to avoid considering a default scenario, according to Elemer Tertak, director of the European Commission's financial markets department, although he stressed that this was "not the final word".

"I don't think the default scenario of any European country is in front of us," said Sylvie Matherat of the Bank of France, one such national regulator.

"We do have a mechanism in Europe to support eurozone countries," she added. "You can't at the same time decide that the stress tests have scenarios that say perhaps that we do not support our countries."

Vulnerable banks

Banks that fail the stress tests would be required to increase their capital ratios - a measure of their ability to absorb future losses.

Banks can raise new capital by issuing new shares - typically seen as an expensive option - or by diverting money away from dividends for shareholders and/or bonuses for employees.

Alternatively, banks can improve their ratios by cutting back on lending - something that may concern governments because it would create a drag on their economies.

Another worry for regulators is that the results a sovereign debt default could panic markets if banks are revealed to be more vulnerable than expected.

"From Shakespeare we know that self-fulfilling prophecies are the worst kind of prophecies," noted Mr Tertak.

Haircuts

Meanwhile, right-wing heads of government from across the EU have been meeting in Helsinki.

The gathering, which includes German Chancellor Angela Merkel and French President Nicolas Sarkozy, will discuss among other things the terms of the new permanent sovereign rescue fund for eurozone governments to be instituted from 2013 onwards.

Also present will be the new Irish Taoiseach-elect Enda Kenny.

He has vowed to demand cheaper lending terms on the Irish Republic's existing bail-out loans, as well as the right to force losses - or "haircuts" - on lenders to the country's dud banks.

A condition of the Republic's rescue by EU partners was that Irish taxpayers should foot the bill for making good on a government guarantee of its banks' debts, angering many voters.

Many economists suggested at the time that European leaders feared a default by Irish banks would lead to a chain reaction of bank failures across Europe's undercapitalised banks.

However, the Germans are pressing for future bail-outs of European governments to go hand-in-hand with a restructuring of their debts - exactly the scenario being debated by Europe's national banking regulators.

The EU is expected to present a comprehensive policy response to sovereign debt crisis on 25 March.