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Latest stress test announcement: more questions than answers

“The European Union's stress tests on banks this year may be tougher and better organised than last year's, but still fall far short of settling the biggest worries over their health.” This was the conclusion of one of the journalists I spoke to on Friday, following the EBA’s announcement on the scenarios and methodology for the 2011 round of EU-wide stress tests.  I have to say I agree with him.

On a more positive note, the core macro-economic scenario diverges more from baseline expectations than last year. Some scenarios have also been strengthened and this year’s stresses have a theoretical probability of occurring once every 33 years, rather than last year’s one-in-twenty.

However, there is still no mention of sovereign debt or default and the macro-economic scenarios in this round do not differ significantly from those in the last.

In essence, despite Friday being billed as the big day, we’ve been left with three key questions: Which banks are to be tested? What’s the magic number relating to core tier one capital? And what exactly is being defined as capital?

One final point to consider on reverse scenarios. Current market buoyancy following events in Libya and Japan shows how difficult it is to plan for unforeseen events and how challenging it is to set a base scenario and adverse scenario. Combine this with all the downgrading that’s been happening in the market recently and the starting point, end point and stress points of these tests becomes even less meaningful. Perhaps it’s the case that the reverse scenario is no longer reverse enough.

Only when we have answers to these key questions will we be able to assess the impact of this next round of tests on banks.

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