Test scenario envisions bond market panic, loss of 7 percentage points of growth over 3 years

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FRANKFURT – European authorities will put their biggest banks through a test scenario that envisions plunging stock, bond and housing markets leading to the loss of a full 7 percentage points of growth over three years.

The European Banking Authority on Tuesday detailed the scenario the banks will be put through to gauge their health. The stress tests are aimed at weeding out shaky banks so financial institutions can better support growth and jobs. Weak lending is a key factor holding back the recovery in Europe and helping keep unemployment high.

Banks will have to maintain adequate financial buffers even if growth falls well short of official predictions through 2016. Those that flunk would have to ask investors for more capital, or take other steps such as cut back on dividends or bonuses.

The test envisions economic output falling 0.7 per cent this year in the 28-country European Union instead of growing of 1.5 per cent, with a drop of 1.5 per cent next year instead of growth of 2 per cent. In the third year, 2016, it envisions weak growth of 0.1 per cent growth instead of the official EU forecast of 1.8 per cent growth.

One trigger for the theoretical downturn would be investors suddenly souring on emerging markets and dumping their investments there. A bond-market slump would spread to other financial markets, and then to EU countries’ economies as world trade declines, hitting foreign demand for their products. Home prices plunge and unemployment skyrockets.

European officials are trying to make this test rougher than a 2011 version applied to 90 banks. Some banks passed that one but had then had to be bailed out by taxpayers. Officials say this test of around 130 of Europe’s biggest banks will be more rigorous because it will be preceded by a review of bank holdings by the European Central Bank. The review will make sure banks’ assets, such as loans, are really worth what the banks say they are. That in turn should make the starting point for the stress test more reliable. Results are expected in October.

EBA head Andrea Enria said the test will be “a robust and effective tool for supervisors to address remaining vulnerabilities in the EU banking sector.”

The economy of the 18 countries that share the euro grew a modest 0.2 per cent in the first quarter, with high unemployment of 11.9 per cent.

Data released Tuesday from the European Central Bank showed bank loans to businesses fell 3.1 per cent in March from the same month a year ago. Analysts say weak lending is a due on the one hand to little demand from businesses unwilling to risk borrowing, and, on the other hand, limited credit offerings from banks who fear a slow economy increases the chance they won’t be paid back.

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