Stress tests: one step forward, two steps back

Louisa Bojesen
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BANKS are back in focus again – and they are not very happy about it. Just after rating agency Standard & Poor’s (S&P) said it may downgrade a number of Italian banks, Moody’s cut Portuguese sovereign debt to junk status. Contagion is once again a real worry.

Jean Claude Trichet, the president of the European Central Bank (ECB), knows this. That’s one reason why the ECB has controversially announced that it will be accepting Portuguese debt as collateral regardless of the rating (it is meant to accept only the safest bonds).

But when looking at Portugal, contagion effects are much smaller than that of Greece. According to National Australia Bank, net Portuguese credit default swaps (CDS) outstanding have fallen from €8.2bn (£7.3bn) in May 2010 to €6.6bn in May 2011, which suggests that in the event of a default losses would be limited.

Around half of Portuguese government debt is held by German, French, and UK banks. The Spanish financial sector has the largest exposure, around €80bn, largely in the non-bank sector.

The results of the latest round of stress tests of European banks is set to be announced this week, but there is still a lot of scepticism. First of all, how much of a difference will they really make? Rewind to the last round of tests – Irish banks came out with flying colours, and just months later had to be bailed out by the Irish state.

Second, there are different levels of test severity depending on the country. How then can it be fully fair to compare the health of the Nordic banks to that of the Spanish? (It seems the Swiss, the Nordic and the UK banks could come out on top in the tests due not only to their limited exposure to periphery sovereign debt, but also as governments in these countries have been harsher with capital requirements).

Third, testing bank exposure to sovereign debt is a step in the right direction. But it seems they still aren’t testing adequately for the crucial element: What happens to the bank in the event of a country defaulting?

And fourth, capital ratios almost appear to be artificially (and sometimes even randomly) set (what exactly is enough?).

The good news is most UK banks are in pretty good shape. They haven’t got big continental exposure – if anything, renewed Irish weakness would be more worrying for them.

Louisa Bojesen is a CNBC anchor.