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Waiting for D-Day: Europe's Financial Giants Nervous Ahead of Stress Test Release

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On Friday, European banking authorities will release the results of the first major stress test of the Europe's banks. Doubts have been raised about the rigor of the tests and some fear it will just be a staged show of stability for the industry. SPIEGEL ONLINE analyzes what the stress tests will actually deliver.

European banking centers, like Frankfurts, are jittery ahead of the publication of stress test results on Friday. Zoom
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European banking centers, like Frankfurts, are jittery ahead of the publication of stress test results on Friday.

Externally, the message is one of calm and tranquillity. With European stress tests set to be released at the end of European trading on Friday, banks and financial oversight authorities are at pains to demonstrate that they have everything under control.

Behind the façade, however, it is a different story. Financial institutions, national oversight authorities and the Committee for European Banking Supervisors (CEBS), which is carrying out the tests, are hectically finalizing their plans for Friday. Exactly when and how the results are to made public was to be the subject of a Thursday conference call among the European Union ministers concerned.

Even the timeline itself, which had seemed set in stone for weeks, was up for debate again this week. The plan to release the results on Friday evening was initially seen as a way to give banks the weekend to react to bad news if they needed to. Suddenly, though, there was talk of already going public on Friday morning. Some were concerned about giving markets in the United States a head start in interpreting the results -- as though nobody had thought of it before. A European Commission spokesperson had to clear the waters -- the original plan remains valid: The results will be released on Friday at 6 p.m.

The last-minute chaos belies the stability the stress tests are supposed to inject into European financial markets. As concerns over sovereign debt have grown in Europe, banks been having an increasingly difficult time raising money. With investors increasingly doubting their durability, Spanish banks, in particular, have complained of trouble. In response, Madrid took the initiative in lobbying for the publication of the stress tests as a way of injecting confidence into European financial markets.

Whether it will work, remains to be seen. Many experts have complained that the tests have not been rigorous enough and worry that the markets won't take them seriously. Some bank managers, meanwhile, worry that too much honesty might harm their institution's image.

But how do the stress tests really work? What is the point? And what effects might they have on European financial markets? SPIEGEL ONLINE takes a look at the most important questions.

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The Stress Test Scenarios
Overview
The stress tests will probe 91 important banks in the European Union to see how they might react to an economic crisis. Fifteen German banks are to be examined. The banks will be tested using three computer-simulated risk scenarios.
Stage One -- Normality
First, the tests will examine how the banks' capital reserves and other core indicators would develop should the euro-zone economy develop as the European Commission expects.

At the beginning of May, the Commission projected EU-wide growth to be 1 percent in 2010 and 1.5 percent in 2011. For the 16 euro zone countries, the Commission expects growth to hit 1 percent in 2010 and 1.7 percent in 2011.
Stage Two -- Crisis
This stage looks at how banks would cope should the European Union economy develop more poorly than expected over the next two years. Aberrations of up to three percentage points from Commission projections will be factored in.

Growth aberrations will vary by country in this scenario. According to financial industry sources, the stage two scenario factors in German GDP growth of 0.2 percent for this year and a shrinkage of 0.6 percent for 2011. By way of comparison, the German economy shrank by 5 percent in 2009.

This scenario also includes a flattening out of the (interest rate) yield curve, a situation which would cause significant problems on the bond markets. Many banks have large bond holdings, making them vulnerable to difficult bond market conditions.
Stage Three -- Crash
Stage three envisions and extension of stage two and involves a crash of European national bond markets. According to the European oversight body CEBS, which is carrying out the stress tests, this stage involves the simulation of a shock, not unlike that which took place at the height of the European debt crisis this spring.

During that crisis, risk premiums on bonds issued by problem countries climbed rapidly. Trading of national bonds -- with the exception of those issued by Germany -- almost came to a complete halt.

The stage three model reproduces that scenario. Banks are to be checked to see how they would handle a rapid increase in spreads (interest rate differences between bonds from troubled countries and the German benchmark bonds) and an increase in national bond returns of 30 basis points, which would result in a decrease in value of those bonds.

This test is likely to hurt banks which hold large quantities of bonds from highly indebted countries such as Greece, Portugal and Spain.
German Banks Being Tested
Deutsche Bank, Commerzbank, Hypo Real Estate Holding, Landesbank Baden-Württemberg, Bayerische Landesbank, DZ Bank AG, Dt. Zentral-Genossenschaftsbank, Norddeutsche Landesbank, Deutsche Postbank, WestLB, HSH Nordbank, Landesbank Hessen-Thüringen, Landesbank Berlin, Dekabank Deutsche Girozentrale, WGZ Bank (Reuters)


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