Olli Rehn, European Commissioner for Economic and Financial Affairs, said the European Union (EU) will conduct a second round of stress test for banks in February 2011.

Rehn made the comments to a news conference after the meeting of EU finance ministers, reported Reuters.

He said the new stress tests will be more rigorous, more comprehensive, and be based on new financial architecture. 

Furthermore, the EU will opt for fullest possible transparency when conducting the bank stress tests.

 

Stress tests on banks are designed to determine if they can withstand adverse economic and financial scenarios in the future. If done properly, the tests will boost the world's confidence in healthy banks and prompt weaker banks to restructure and/or recapitalize.

 

Back in July, the EU published the results of its first round of bank stress tests. Even though only seven banks failed them, the market thought the criteria for the stress scenarios were too lenient. 

 

Specifically, such overly lenient criteria included reduction in GDP growths rates, the haircuts to sovereign bonds, and the fact that haircuts did not apply to sovereign bonds held to maturity but only to those held in trading-book portfolios.

 

This last criteria essentially assumed no sovereign defaults, which is a rather optimistic expectation considering the poor fiscal state of certain peripheral EU members.

 

Consequently, confidence in EU's banking sector was not boosted by the stress tests and weaker banks were not nudged into significant re-capitalization or restructuring. 

 

Moreover, critics now point to the fact that all Irish banks passed the stress tests.  However, these banks, as the world has seen recently, are clearly not healthy and are cited as the main fundamental factor behind Ireland's sovereign debt crisis, which had led to a massive EU bailout and a severe austerity budget by the Irish government.

 

Nevertheless, Rehn very strongly defend[s] the conduct and results of the [first] bank stress tests.  He did concede that one of the lessons learnt is that we will need to have a liquidity assessment.

 

However, arguably the biggest complaint of the first round (regarding the lack of haircuts for sovereign bonds held to maturity) was not merely a liquidity issue, but rather concerns about the solvency of certain peripheral European countries. 

 

Boris Schlossberg, head of global currency research of GFT Forex said the new stress tests is a move in the right direction, [but won't be] enough to ease the concerns of the credit markets because the critical issue is the ability of [certain] members of EU to finance their revenues. 

 

At this point, the market is viewing [it] as a solvency rather than a liquidity problem, he said. 

 

Email Hao Li at hao.li@ibtimes.com