The EU Stress Test: It’s Not an Exercise

Posted by ESmith

July 26, 2010

The financial news channels have been filled with news about the European Bank Stress Test for the last few days. If you’re not a big fan of economic news, you probably haven’t even heard of it or the controversy about it that ensued. Over a year ago, Dinner Topics briefly explained the idea of bank stress tests. This time around, we want to give you a little more detail to bring to the table.

Well, the European Union decided that there should be a gauge that measures how well a certain bank can withstand a recession. They decided that this stress test should solve the problem. They looked at each bank’s Tier 1 capital ratio, which is the ratio between that bank’s core capital (safe from any risks) and that bank’s riskier assets. This ratio does make sense; if a bank has more safe assets than risky assets, then that bank should be able to withstand a recession. However, skeptics dismiss the test, saying that the test was not as strict as it should be, letting banks that would otherwise fail slip through the cracks.

The results of the test show that out of the 91 banks that were tested, seven failed to be within the 6% Tier 1 capital ratio threshold. Five of the seven banks that failed were in Spain, one was in Germany, and one was in Greece. The German bank was a surprise because Germany is not in PIIGS (explained here). The Euro actually dropped against most currencies the day the results were released, July 23. Even if the tests were flawed, they did affect the world economy.