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Market Update

Devil in the Details of European Bank Stress Tests

The most interesting part of the European Banking Authority's stress test lies not in the headlines.

The European Banking Authority (EBA) today released the long-awaited results of its bank stress tests. The market seems as unsurprised by the headline results as we are. None of the European banks that we cover failed, and only eight of the 90 banks tested failed. The eight that failed include two state-owned Greek banks, four Spanish cajas and one Spanish bank, and one bank in Austria. All of the banks in Ireland, Italy, France, Germany, and the U.K. passed.

We think the most interesting part of the stress test lies not in the headlines but in the details. Once again, the stress tests did not include the potential impact of a sovereign default. While we see this as a flaw--the possibility of a sovereign default is one of the most important questions currently facing investors--we understand the political difficulties of including it. Importantly, the EBA results include detailed figures that quantify the sovereign debt holdings of each financial institution by country, as well as private debt holdings disclosed by type and country. We think this will make it relatively easy for investors to make the necessary calculations. For example, Deutsche Bank (DB) holds net EUR 5.3 billion in Italian sovereign debt and has EUR 40 billion of other loans there. A large negative shock in Italy would quickly consume a large chunk of the bank's EUR 30 billion of common equity.

We welcome these detailed disclosures, as we have long complained that European bank disclosures are inferior to U.S. disclosures and are inadequate for investors to judge the risk they are taking on. While the details are likely a one-time event, we'll continue to dig into them and parse out which are the riskiest institutions, and which ones investors have been throwing out with the bath water.

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Erin Davis does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.