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European Bank Stress Tests: The Central Bank and Financial Regulator today published the results of a stress testing exercise carried out on AIB and Bank of Ireland and coordinated by the Committee of European Banking Supervisors (CEBS). It said the results of the exercise demonstrate that AIB and Bank of Ireland meet the stress requirements and do not require additional capital beyond the requirement set in March 2010 by the Central Bank and Financial Regulator following completion of the Prudential Capital Assessment Review (PCAR) in March. The CEBS said  7 of 91 banks failed  - - 5 Spanish, 1 German and 1 Greek.

Execution of the capital plans resulting from the PCAR assessment is already underway. Bank of Ireland has already exceeded its capital requirement and AIB has an approved capital plan to meet the requirement by December 2010 involving asset disposals and equity raising underwritten by the Irish government.

Commenting on the results of the European exercise, Head of Financial Regulation at the Central Bank, Matthew Elderfield said "The stress test results published today for Ireland’s two largest banks as part of a Europe-wide exercise follow the Central Bank and Financial Regulator’s own stress testing process earlier this year under our Prudential Capital Assessment Review (PCAR) framework. The PCAR stresses were set at a severe stress level and it is therefore consistent with our earlier exercise that the Irish banks have achieved the target level of capital in the EU process. In our application of the EU stress test we have, as a prudent measure, decided to apply a number of the more demanding PCAR parameters - the Irish banks also meet the target level of capital against this standard, but with less headroom."

He added, "These results take account of the additional capital previously prescribed by the Central Bank under the PCAR. Bank of Ireland has already met these targets and we continue to work with AIB as it executes its capital raising plan to meet our year end-deadline. We are also continuing our PCAR work with the other Irish banks and will keep the capital position of the Irish banking sector under review, conducting further stress testing exercises in the future to benchmark prudential capital requirements in light of market developments."

The Central Bank said objective of the EU-wide stress test exercise was mandated by the EU Council of Ministers of Finance (ECOFIN) and coordinated by CEBS in cooperation with the European Central Bank, national regulators and the EU Commission, to assess the overall resilience of the EU banking sector and the banks’ ability to absorb further possible shocks on credit and market risks, including sovereign risks.

"Everybody has been surprised by the small amount of money that would need to be raised by only seven banks," Christophe Nijdam from AlphaValue told CNBC after the results of the EU's bank stress tests were released Friday:

The exercise was carried out on a bank-by-bank basis for a sample of 91 EU banks from 20 EU Member States, covering at least 50% of the banking sector, in terms of total consolidated assets, in each of the 27 EU Member States. The exercise used commonly agreed macro-economic scenarios (benchmark and adverse) for 2010 and 2011, in cooperation with the ECB and the European Commission.

The stress test required banks to meet a 6% Tier 1 target capital ratio. It was conducted using country and market specific methodologies, shocks and assumptions provided by CEBS including loan loss rates, resulting from Probability of Default (PD) and Loss Given Default (LGD) estimates, on loan books and market shocks to trading books. The test additionally applied stress parameters to both banking and trading books for a sustained sovereign stress.

In completing the CEBS stress test, the Central Bank and Financial Regulator applied higher loan loss rates to both the NAMA loans and the non-NAMA investment and development property loans than was required by CEBS. In each of these loan categories the PCAR loss rates were applied. This resulted in a more demanding stress test than was prescribed by CEBS due to the specific PCAR loss rates applied to these exposures.

Assessing the bank stress tests, with Gavan Nolan, Markit and Simon Smith, FXPro:

Both the CEBS and PCAR exercises have subjected AIB and Bank of Ireland to rigorous stress testing, scrutiny and challenge. While both have different assumptions and methodologies, they apply a robust, realistic and prudent capital standard informed by detailed analysis and by emerging best practice internationally. Results of the CEBS stress test and the CEBS stress with the Central Bank and Financial Regulator adjustments for NAMA and non-NAMA property loans are shown in the table. The adjusted CEBS stress test outcomes are the results that have been provided to CEBS.

Table 2. Valuation haircuts to sovereign debt holdings as applied in the exercise

Bloomberg said the stress tests on 91 banks took account of bank losses only on government bonds they trade rather than those they hold to maturity, according to a draft European Central Bank document.

“The haircuts are applied to the trading book portfolios only, as no default assumption was considered,” according to a confidential document dated July 22nd and titled “EU Stress Test Exercise: Key Messages on Methodological Issues.”

The tests assumed a loss of 23.1% on Greek debt, 14% of Portuguese bonds, 12.3% on Spanish debt, and 4.7% on German state debt, according to the document obtained by Bloomberg News. UK government bonds were subject to a 10%t haircut, and France 5.9%.

The decision “allows banks to basically underestimate their exposure to distressed peripheral debt,” Brown Brothers Harriman, the New York private bank founded almost 200 years ago, said in a note to clients today. “By leaving out stress tests on the banking book, then a true picture of bank balance sheets will clearly not be obtained.”

The tests assume the weighted average yield on euro-area five-year government bonds will rise to 4.6% in 2011 from 2.7% at the end of 2009. The tests also include an increase in the yield on five-year Greek government bonds to as much as 13.9% after “interest rate shocks,” the document shows.

“The haircuts on government debt in the trading book increase according to the introduction of sovereign risk, which is modeled as an increase in government bond spreads in line with market developments since the beginning of May 2010,” according to the document.

The EU's bank stress tests were harder than those of the past, French Finance Minister Christine Lagarde told CNBC Friday after the test results were released:

CEBS

The CEBS said the exercise includes a sample of 91 European banks, representing 65% of the European market in terms of total assets, in coordination with 20 national supervisory authorities. It has been conducted over a 2 years horizon, until the end of 2011, under severe assumptions. The stress test focuses mainly on credit and market risks, including the exposures to European sovereign debt. CEBS has coordinated the exercise and conducted extensive cross-checks over the results, which were submitted to a rigorous peer review process in order to ensure their consistency and comparability.

The report provides details on the scenarios, methodologies and aggregate results of the stress test exercise.

In total, aggregate impairment and trading losses under the adverse scenario and additional sovereign shock would amount to €566bn  over the years 2010-2010.

The aggregate Tier 1 ratio, used as a common measure of banks’ resilience to shocks, under the adverse scenario would decrease from 10.3% in 2009 to 9.2% by the end of 2011 (compared to the regulatory minimum of 4% and to the threshold of 6% set up for this exercise). The aggregate results depend partly on the continued reliance on government support for currently 38 institutions in the exercise.

The aggregate Tier 1 ratio incorporates approximately 197bn € of government capital support provided until 1 July 2010, which represents 1.2 percentage point of the aggregate Tier 1 ratio.

As a result of the adverse scenario after a sovereign shock, 7 banks would see their Tier 1 capital ratios fall below 6%.

The threshold of 6% is used as a benchmark solely for the purpose of this stress test exercise. The CEBS said this threshold should by no means be interpreted as a regulatory minimum. All banks that are supervised in the EU need to have at least a regulatory minimum of 4% Tier 1 capital.

For the institutions that failed to meet the threshold for this stress test exercise, the competent national authorities are in close contact with these banks to assess the results of the test and their implications, in particular in terms of need for recapitalisation.

Results of the individual banks and statements on follow-up actions, where needed, are provided by the banks participating in the exercise and/or their national supervisory authorities.

"We support, in particular, the transparency of this exercise, given the specific market circumstances under which banks currently operate. We therefore welcome the publication of banks’ individual results, particularly their respective capital positions and loss estimates under an adverse scenario, as well as detailed information on banks’ exposures to EU/EEA central and local government debt," the CEBS said.

The Committee of European Banking Supervisors discusses the bank stress test methodology and the organization's conclusion about which banks are at risk: