Stress testing a bank's balance sheet means calculating what would happen to it if something nasty happens for example a 30% drop in the equities market. Euro banks are stuffed with Eurozone sovereign debt so asking what would happen if one or more of Eurozone countries defaults on its debt seems a reasonable test to apply. This is a big problem for the EU as they have proclaimed no Eurozone country will default. So to include such a scenario in a stress test is to admit it could happen and is therefore politically unacceptable. The EU solution? Easy, just don't include that scenario in the test. The problem? Those nasty Anglo Saxon markets won't swallow it. Even the German media have called it a 'stress test without stress'!
Already the delectable Madame Lagarde, the French finance minister has stated the tests will show that Europe's banks are 'solid and healthy' before the tests have even been done. Le test c'est moi so to speak from our latter day Madame de Pompadour. Even ECB margin or haircut levels for different countries applied in these tests will inevitably become public knowledge and the EU fears the queues at the bank doors will soon start. Even a pretty modest haircut of say 3% on sovereign debt would leave German banks with €47 bn of losses according to AEP in today's DT. He also reports a market source saying the ECB is not buying Spanish corporate bonds. Sounds like the rain in Spain is expected soon on Spanish Cajas.
Private investors are already pricing in a 50% 'haircut' on longer dated Greek bonds and something approaching 30% on similar Spanish bonds. These bonds are widely held by all Euroland banks so you can see that a stress test based on haircuts of that magnitude would leave few Euroland banks looking solvent. Worse, there would be a domino or correlation effect to transmit the contagion from one country to another and this again would not be politically acceptable to include in a stress test.
Being helpful the EU will allow banks to run their own stress tests, a bit like marking your own exam paper. It ensures none shall fail and politicians can have their grande vaccances. Only the hair shirted Brits applied independent stress tests through their now politically discredited FSA.
But why do Euro banks hold such high levels of sovereign debt. Well it can be sold to gullible investors as a nice low risk lucrative strategy called a carry trade. Buy a 10 year sovereign bond yielding conservatively 4% with money borrowed at 0.5% from the ECB and pocket a nice turn until the sovereign issuer stops paying the bond coupon or even worse cannot meet the capital redemption.
For politicians seeking re-election there is another facet to this problem. Taking bigger haircuts reduces a bank's Tier One capital that determines how much a bank can lend. Reducing tier one capital from say 10% to 8% of its deposits means not a 2% reduction in bank lending but something over 20% reduction in lending. This would push most of the Eurozone into a double dip recession and bring the workers out onto the streets seeking politicians blood. Good luck to them and vive la revolution!