ECB paves way for next year's tougher-than-expected bank stress test

The European Central Bank (ECB) today announced that the stress test it'll be meting out on Eurozone banks as of this November will be tougher than many had anticipated. (Release)

The three-part assessment will require all banks to have a capital ratio of eight per cent, and will take 12 months to complete.

Michael Symonds of Daiwa Capital Markets comments that the eight per cent capital benchmark for all banks "may challenge smaller banks". Many had expected of a seven per cent benchmark, with eight per cent reserved for larger banks only.

The comprehensive tests are designed to wheedle out hidden risks in balance sheets and capital shortfalls. 128 lenders - accounting for around 85 per cent of the Euro area banking system - will be scrutinised by the ECB in what is a move by the bank to assume full responsibility for financial establishments, as part of the single supervisory mechanism.

The assessment will be carried out in collaboration with the national competent authorities of the member states that participate in the single supervisory mechanism.

The exercise, says the ECB, has three main goals: transparency, repair and confidence building. The corrective measures will seek to assess asset quality, enhancing information and trust. If shortfalls are identified, said ECB president Mario Draghi, banks will be required to make up for them.

Draghi said, “A single comprehensive assessment, uniformly applied to all significant banks… is an important step forward for Europe and for the future of the euro area economy. Transparency will be its primary objective. We expect that this assessment will strengthen private sector confidence in the soundness of euro area banks and in the quality of their balance sheets.”

A provisional list of banks to be tested includes 24 German banks, 16 Spanish, 15 Italian, 13 French, seven in the Netherlands, five in Ireland and four in each of Greece, Cyprus and Portugal.

The absence of more nuanced detail, such as the treatment of banks' LTRO borrowings and sovereign debt holdings, hasn't been included in today's broad overview, points out Symonds. He adds: "based on just this initial top-level detail as well as lingering doubts over the credibility of recapitalisation backstops, the jury will remain out over the overall rigour of the process."

Berenberg's Christian Schulz says the testing could be a risky endeavour:

Banking union is designed to restore “normal” credit provision across the Eurozone. In the meantime, the lengthy process risks doing the opposite. Banks may stay away from any risky business even more to look as safe as possible for the new supervisor. According to the ECB’s release today, the process of recapitalising banks could take into 2015. The ECB encourages banks and national governments to act already while the comprehensive assessment goes on until October 2014. But the ECB will only force them to act from November 2014 onwards, giving them an as yet unspecified time period to complete the process. Put differently: Some major European banks may still have a reason to grant few new loans and hence incur new risks until some time in 2015.