Seven European banks would not be strong enough to withstand another recession and would face a capital shortfall of 3.5 billion euros ($4.5 billion), tests run in an attempt to revive investor confidence showed on Friday.
Five of Spain's smaller regional lenders, known as cajas, failed the test and their recapitalization is likely to speed a restructuring of the troubled sector.
Banks in Germany and Greece were also seen as weak spots and in need of restructuring, but state-owned Hypo Real Estate was the only German lender to flunk and state-controlled ATEbank was the only Greek bank to fail.
Analysts had expected five to 10 banks to fail the test. As expected, no big banks failed the health check.
German government bond futures hit one-month lows and the euro briefly pared its losses against the dollar after the results were released.
Europe tested how 91 banks would cope with another recession and losses on government debt after the Greek crisis hit markets and raised fears the euro zone could unravel.
It aimed to repeat a health check on U.S. banks last year that helped restore investor confidence and underpinned a recovery by bank shares.
The Committee of European Bank Supervisors said its test was more severe than the U.S. health check of its banks. The adverse scenario in Europe was a one in 20 years possibility, compared to a one in 7 years probability in the U.S. test, it said.
But markets have had their doubts.
"I see nothing stressful about this test. It's like sending the banks away for a weekend of R&R," said Stephen Pope, chief global equity strategist at Cantor.
Under the most severe scenario banks were tested on how they would cope with a moderate recession this year and next, with additional losses on government bonds.
Any bank whose Tier 1 capital ratio falls below 6 percent by the end of 2011 failed the test, and would be expected to raise funds to make up the capital shortfall.
Of most concern to investors was that government bond losses were only applied to trading books, and not hold to maturity bonds, as the test did not consider there was a risk of any sovereign default.
Banks' holdings of government bonds were subjected to a 23.1 percent loss on their Greek debt, a 12.3 percent loss on Spanish bonds and a 4.7 percent loss on German debt, all based on 5-year bonds and their value at the end of 2009.
SPAIN, GERMANY IN SPOTLIGHT
The hunt for weak spots in European banking has focused on Spain's regional savings banks, as well as regional German lenders, known as landesbanks.
Spain and Germany have set up funds to help weak banks recapitalize and Spain wants more cajas to merge.
With the latest data showing signs of a strengthening recovery in Europe, banks could find themselves in a healthier position than expected.
A stress test on U.S. banks early last year helped draw a line under worries about the sector there. European regulators were aiming to achieve the same.
But there have been clear splits in the 27-nation EU about how to model the test and how much to divulge, stoking worries that it will be less credible.
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