The European Union will stress-test its 25 biggest banks under the scenario of a slowdown in economic growth and stress on sovereign debt holdings, a senior euro zone source said on Friday.
The tests will be conducted by national supervisors under management by the Committee of European Banking Supervisors (CEBS) and in the second stage extend to more banks than the initial 25, the source said.
"CEBS has been doing this for quite some time. These are agreed criteria with a macroeconomic stress scenario that has been agreed with the ECB, simulating first a growth slowdown ... and also simulating stress on sovereign holdings," he said.
"They are now working on phase two, which will extend the results to well beyond the 25 largest banks."
The EU conducted an aggregated stress test of its 22 biggest cross-border lenders representing 60 percent of the assets of the 27-country bloc's banking sector last year, under the scenario of deep recession in 2009 and 2010.
The test concluded that the EU banking system as a whole was sound and could withstand a much worse economic downturn than had taken place.
"CEBS has been working on an EU-wide stress testing exercise since the beginning of the year, in coordination with the European Commission and the European Central Bank. The idea is to test banks in 'what if' scenarios," a CEBS spokeswoman said.
Euro zone sources said all individual bank results would be published, including capital ratios.
"These are mechanical exercises to see how much stress from one part of the assets the banks can stand, and then you add them up," the source said.
The idea of the stress tests, announced by EU leaders on Thursday, originated at a conference call of G-7 finance ministers on June 14, euro zone sources said.
"The idea was that being secretive about this would not be reassuring for markets," a second euro zone source said. "The ministers thought this might help restore a little bit of confidence."
The EU leaders' decision to make the results public was triggered by the decision of Spain to do so on Wednesday because if other countries did not follow Madrid, markets could suspect they had something to hide, euro zone sources said.
The EU stress tests, however, will not be compatible with stress tests that the United States conducted for its own financial institutions.
"The Americans have run an extremely soft stress test and first looked at how much money they wanted to give the banks.
Then they calibrated the stress tests until they had exactly that amount coming out of the stress test," the first source said.
"It was not really a stress test. It was an excuse for handing over some money," the first source said.
If the EU tests showed a bank was in trouble, the relevant government would announce what it would do to help the lender.
"In parallel with the publication of the individual results, if necessary, governments will be expected to say what course of action they can envisage," the first source said.
"Under no circumstances would a bank, which may be under distress, be left out in the cold," the source said.
Another euro zone source said the European Central Bank had insisted there be sufficient programs for bank capitalization in case the test results were poor.
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