UPDATE: EU states ready to rescue stress-test failures.
The European Banking Authority announced on Friday the publication date for the results of its check on 91 of the region's top lenders. These will be accompanied by measures to bolster capital for those that failed or nearly failed, in another attempt to reassure investors that European banks can withstand future shocks.
According to a separate European Union draft document seen by Reuters, European countries will support banks that fail the stress tests if those lenders cannot raise capital from investors within six months.
The paper, being prepared for EU finance ministers to approve on Tuesday, is an about-face from promises by G20 policymakers in the wake of the financial crisis that taxpayers would never have to bail out banks again.
However, the EBA appeared to give banks a longer grace period. It said in a statement they would have to disclose next week how they will plug capital gaps by the end of 2012, giving them longer than markets had assumed to raise new capital.
This latest round of tests has been touted as being more rigorous than previous attempts, in which few banks failed, and finance ministers' officials are drawing up plans for how to deal with the fallout.
The document also says lenders that nearly fail the tests will be put on a critical watch list in case they deteriorate further.
Banks that fail will be given until the end of September to draw up a plan to repair their finances and then three months to implement it.
Sources close to the banks and watchdogs said all German banks were certain they would get the green light, although some lenders, including publicly-owned landesbanks HSH Nordbank and NordLB , would just scrape through.
News that EU governments appear serious about supporting banks that fail to maintain core capital of 5% in the face of several theoretical markets shocks lifted Bund futures and UK gilts.
"In essence that puts even more pressure on the periphery (euro zone countries) to come up with measures, not only to shore up their budgets, but to support their banking sectors, which they can ill afford to do," said Marc Ostwald, strategist at Monument Securities.
"It's basically a charge to safety on the back of this.
This is a market which is living in mortal fear of anything to do with the euro zone and anything that puts the banking sector under more stress," Ostwald said.
The Italian/German 10-year yield spread hit fresh euro-era highs amid fears that already fiscally stretched countries like Italy might have to dig into their pockets to bail out banks that fail the test as well.
Shares in Italian bank UniCredit fell more than 5 percent on fears that Italy could be pulled into the debt crisis that has already forced Greece, Ireland and Portugal to take bailouts. UniCredit is the only big Italian bank that has not yet announced a capital increase.
Italian banking association chief Giuseppe Mussari, when asked about possible government intervention for banks failing the stress test, said this was not an issue for Italian banks.
PRIVATE SECTOR FIRST According to the draft EU document, capital-raising plans should first be based on "private-sector measures, including ...
retained earnings ... raising additional common equity or high-quality hybrid instruments from private investors, assets sales, mergers." But if the search for private capital leads nowhere, then governments should be ready to step in.
Officials do, however, make provision for "the extreme case" if efforts to rehabilitate a bank fail and it threatens wider stability, recommending "a process of orderly restructuring and resolution".
The number of banks declared by the EBA to have failed will either encourage investors that Europe is now coming clean with its banking problems, or if the tests are deemed too lax again, they will hurt the EU's already battered credibility.
Previous stress tests were widely dismissed as too lax -- all Irish banks passed last year's test just months before the EU and International Monetary Fund had to bail them and the country out.
SEPTEMBER DEADLINE In the draft document, dated July 7, officials write that banks that miss the 5% capital pass mark will be given until the end of September at the latest to submit recapitalisation plans, with a further three months to implement "private-sector measures".
"If the relevant banks are unable to implement a credible capital plan by the specified deadlines, the (government) stands ready to take necessary measures to maintain financial stability," officials write in the document seen by Reuters.
The new checks will measure how well the core capital that banks rely on to absorb losses such as unpaid loans holds up when exposed to an economic dip or fall in property prices.
They also gauge the impact on banks should government bonds they own, issued by states such as Greece, lose value.
Those banks that come uncomfortably close to the 5 percent threshold will also be singled out for special attention.
"Banks where the (core tier 1) ratio is above but close to the 5 percent benchmark under the stress scenario will be subject to reinforced prudential scrutiny so as to ensure that there is no unexpected deterioration in their capital position."
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