Late on Friday, July 15, 2011, the European Banking Authority (EBA)?a new supranational regulator which seems to be adding to the growing cloud of regulatory confusion/uncertainty covering Europe?s financial sector since September 2008?published the findings of its stress tests on 91 banks in the EU. Its report notes that:

?The 2011 EBA?s EU wide stress test ? assesses banks against deterioration from a baseline forecast in the main macroeconomic variables such as GDP, unemployment and house prices?for instance, GDP falling 4% from the baseline. The scenario includes a sovereign stress, with haircuts applied to sovereign and bank exposures in the trading book, and increased provisions for these exposures in the banking book. Changes in interest rates and sovereign spreads also affect the cost of funding for banks in the stress. The methodology ?, entails a static balance-sheet assumption which does not allow banks to react to shocks. The resilience of the banks is assessed against a benchmark defined with reference to capital of the highest quality?Core Tier 1 (CT1)?set at 5% of risk weighted assets (RWA).?

An abbreviated summary of the stress tests showed that:

n In mid-July 2011, 9 banks fell below the 5% Core Tier 1 Ratio (CT1R) threshold with an overall CT1 capital shortfall of 2.5 billion euros.

This was after: (a) 20 banks had fallen below the 5% CT1R threshold with an overall shortfall of 26.8 billion euros on CT1Rs for the end of 2010; and (b) 50 billion euros of new Tier 1 capital was raised by these and other banks between January and April 2011.

16 other banks had a CT1R of only 5-6%.

5 of the 8 failing banks were Spanish?Banco Pastor and four unlisted savings banks, Catalunya Caixa, Unnim, Caja3, and CAM. Yet, the Bank of Spain asserted that none would be required to increase CT1 capital, putting the national regulator in conflict with the EBA.

Unlike other EU members, Spain asked for nearly all of its banks to be stress-tested to assuage European financial markets. About 95% of Spanish commercial and savings banks were tested against an EU average of about 60%.

2 Greek banks?the state-owned ATE Bank and the private EFG Eurobank?failed the stress tests based on end-2010 figures. Both have since raised their CT1Rs above 5%. ATE, which had a CT1R of -0.8% at end 2010, increased it to 10.7% following a 1.2-billion euro capital injection ahead of its privatisation. EFG, the country?s second-largest lender, which had a CT1R of 4.9% at end 2010, has since raised it to 7.6% by selling its Polish subsidiary.

The other failures were Austria?s Volksbanken and Germany?s Helaba, which asked for its results to be withheld after disagreeing with the EBA over the quality of its capital. The 12 German banks remaining in the test?after Helaba withdrew and BaFin, the national bank regulator, criticised EBA for removing hybrid capital from its definition of CT1 capital?passed with an average of CT1R of 7.5%. The lowest was HSH Nordbank, one of the group of public sector Landesbanken, with a CT1R of 5.5%. NordLB, another Landesbank, had converted some hybrid capital in April to achieve a score of 5.6% while Deutsche Bank, the country?s biggest, had a CT1R of 6.5% and Commerzbank of 6.4%.

Portugal?s 4 largest banks met the EBA?s benchmarks for 2011; 2 will need to raise more capital for 2012. Banco Comercial Portugu?s will have to raise capital or shrink its assets to the tune of nearly 400 million euros to meet the more demanding CT1R benchmark of 6% for 2012; while the Esp?rito Santo Financial Group will need to raise 145 million euros to meet the same target.

n Italy?s top 5 banks passed with surprising ease. Its central bank said the results reflected the ability of their balance sheets to absorb a much higher level of market and macro-economic volatility than experienced in the past week. Intesa Sanpaolo came out best under the adverse scenario for 2012 with a CT1R of 8.9% after its recent 5-billion euro rights issue. UniCredit, the only large Italian bank that has not yet made a rights issue, came out with a CT1R of 6.7% under the same scenario. It is expected to go to the market for capital in the coming months.

French banks came out with CT1Rs significantly higher than 5%. Yet, they are among the most heavily exposed to Greek debt. BNP Paribas, which has the highest exposure to EU peripheral sovereign debt, had a CT1R of 7.9%; Cr?dit Agricole had 8.5% but Soci?t? G?n?rale, which has raised capital twice since 2008, had the lowest CT1R of 6.6%.

The 3 Irish banks tested, i.e., Bank of Ireland, Allied Irish and Irish Life & Permanent, all passed with ratios of 7.1%, 10% and 20.4% respectively?following government bailouts when they failed almost immediately after EBA had passed them on previous stress tests last year.

Britain?s 4 large high-street banks, despite their disproportionate exposure to Irish public and private debt, all passed. But they were hit by the impact of new assumptions. An average CT1R of 10.1% before the stresses were modelled was cut to 7.6% in the 2012 scenario. That was the steepest reduction of any country other than Greece. RBS was the weakest performer with a CT1R of 6.3%, followed by Barclays with 7.3%, Lloyds with 7.7% and HSBC with 8.5%.

Based on these results, the EBA has asked national supervisory authorities in the EU to require banks with a CT1R below 5% to promptly remedy their capital shortfalls. But, the EBA noted that this alone would not be sufficient to address all potential risk vulnerabilities. So EBA has also recommended that national supervisory authorities ask all banks whose CT1R was above (but close to) 5%, and which had sizeable exposures to sovereign debt under stress, to take further steps to strengthen their capital positions. These included dividend restrictions, deleveraging, issuing fresh capital, or conversion of lower-quality instruments into CT1 capital.

The findings of the EBA?s full report still have to be analysed in microscopic detail by banking analysts in global financial markets. But the early reactions of informed pundits/sceptics are as might have been expected. In many ways, the results seem counter-intuitive. Many more banks passed than had been expected. Europe?s financial markets had signalled that 15-20 banks might fail. The aggregate CT1R shortfall of 2.5 billion euros across the EU banking system was a fraction of what markets had anticipated (25-30 billion euros).

Interestingly, in asking readers to interpret its findings, the EBA?s report confesses: ?While the features of the adverse scenario are still in line with the commitment of the European Union to prevent its Member States from defaulting on liabilities, a further deterioration in the sovereign debt crisis might raise significant challenges, both on the valuation of banks holdings of sovereign debt and through sharp changes in investors? risk appetite. In turn this could lead to funding pressure (in terms of both cost and availability) affecting some banks? earning power and internal capital generation capacity which, if not promptly addressed by the banks and their national authorities, could further affect market confidence in these banks.?

If these caveats are taken seriously, one must be worried. On past and current form, there is a high probability that the sovereign debt crisis in the EU will continue to be mismanaged by politicians who do not appear to understand financial market dynamics. They do not seem to grasp what is at stake, how easily it can unravel if they keep playing ?pass the parcel? and applying string-and-sellotape solutions to what is clearly a deep-rooted structural problem.

Simply because the debt crisis has so far affected the EU?s periphery, it does not mean that solutions at the margin can continue to be applied on a quarter-by-quarter, crisis-by-crisis, country-by-country, basis without inviting meltdown at some point, which may be more imminent than the EU?s complacent (and possibly clueless) leaders seem to think.

They have averted disaster so far but at great expense to the indebted countries, whose debt has ballooned in the last year without any tangible benefits for them. It is now a situation in which the balance sheet of the EU as a whole has to be deployed, decisively and resolutely, to convince financial markets that contagion, which has spread to Italy and Spain, can be stemmed and reversed. If that is not done, the embrace of mutual assured destruction (MAD), which European banks and governments find themselves involuntarily locked in, will result in both falling off a cliff; unable to extricate themselves from the fatal attachment each has foisted on the other. If that concerned only them the rest of the world might get way with looking on at them with amazement, pity and sympathy. But if (when?) they both fall off that cliff, there is the risk that they will take a large part of the world, and the world?s banks with them as well.

The author is chairman, Oxford International Associates Ltd