BRUSSELS: European banks can weather a severe economic crisis with a sharp drop in their financial reserves, according to results from an extensive stress test published on Friday. In the worst-case scenario, described as "very severe" and covering a period of three years, the European banking sector would suffer a capital loss of 265 billion euros ($314 billion) by 2023, the European Banking Authority said in a statement. While erosion of core capital-which regulators use to gauge a bank's financial soundness-was within acceptable limits, shareholders in major lenders including PNB Paribas and Deutsche Bank would be looking at big losses, driven by bad loans.

"The assumptions made were unbelievably harsh," grumbled one bank boss, who declined to be identified. "This test has a somewhat artificial side, where we pretend, for example, that in a 100-year crisis we would continue to extend credit as if nothing had happened." The worst-case scenario imagines starting from an already weak economic environment in 2020 and is based on an extended pandemic, a strong drop in confidence and prolonged low-interest rate environment.

The modelling predicts a fall in the European Union's gross domestic product of more than 3 percent over three years, with the economy shrinking in all countries. Following such a shock, the average "tier one" capital ratio, a key indicator of financial soundness, would fall from about 15 percent to around 10 percent, a level generally considered acceptable by supervisors after three years of stress.

Capital erosion

The test, conducted jointly with the European Central Bank, was based on a sample of 50 banks representing 70 percent of the bloc's total banking assets. Twenty of the 50 banks would have seen core capital fall below 10 percent at the end of the three years, according to the test.

The Italian bank Monte dei Paschi di Siena, which has been in difficulty for a long time and is in the process of being taken over by UniCredit, would even be facing negative capital of -0.10 percent. Moreover, some banks would have suffered very heavy losses by the end of 2021: BNP Paribas, 11 billion euros; Deutsche Bank, more than 10 billion euros; and Spain's Santander, more than 5 billion.

But in general, European institutions are proving to be "robust" and "have generally passed the test well", ECB Vice-President Luis De Guindos said in an interview with the German daily Handelsblatt published on Friday. The test revealed deterioration of capital would be more marked among institutions with little international diversification and for those with lower interest income, said the European Banking Authority.

As in previous tests, bad loans accounted for the bulk of the capital deterioration. The heaviest losses were predicted in France, followed by Germany and Italy. The scenario examined would also result in a significant decrease in profits, driven by the lower interest income banks make from lending. Initially planned for 2020, this test was postponed to 2021 because of the global pandemic. - AFP