European regulators to test banks' strength against financial shocks

European regulators will test banks’ financial strength against two years of economic contraction, falling commodity and property prices and further regulatory fines as fears mount over lenders’ ability to withstand shocks.

The European Banking Authority said on Wednesday its annual stress test programme – which covers UK banks Barclays, HSBC, Lloyds Banking Group andRoyal Bank of Scotland – would assess banks’ resilience when faced with a slowing global economy.

The main risk categories the EBA will test are: falling prices of assets such as commodities and property, weak profits for banks, risk of debt default by countries and companies, and strains in money market funds and other parts of the financial system outside the banking sector.

Specific risks within those categories include potential fines for misconduct, an unexpectedly sharp slowdown in China and other emerging markets, sovereign debt default and deflation. Under the EBA’s “adverse scenario”, the European Union’s economy would contract 1.2% this year and 1.3% next year before expanding by 0.7% in 2018.

The tests cover 51 banks making up 70% of Europe’s banking system: 37 in the eurozone and 14 outside the single currency bloc. The EBA said that, unlike in previous years, its tests would not pass or fail banks and no capital thresholds had been set. The EBA said in general it believed banks had enough loss-absorbing capital to withstand potential shocks.

The EBA said: “The objective of the crisis stress tests was to identify possible capital shortfalls and require immediate recapitalisation actions. As banks have now moved to a more steady-state setting, the aim of the 2016 exercise is rather to assess remaining vulnerabilities and understand the impact of hypothetical adverse market dynamics on banks.”

No banks from Portugal will be subject to the tests because they are not deemed systemically important even though Portuguese banks are seen as weak. There was also surprise that theimpact of negative interest rates, one of the big fears for the sector this year, would not play a big part in the tests. The risk of Britain voting to leave the EU on 23 June is not included either.

Bank share prices have tumbled this year as investors have worried about risks such as rising bad debts and lower revenues, as the global economy slows and central banks experiment with negative interest rates. Other perceived threats include further big regulatory fines and the effect of plunging prices for oil and other commodities.

The rout of bank shares has prompted companies such as Deutsche Bank and Credit Suisse to proclaim their own financial strength. One of the concerns is the use of negative interest rates – when a central bank charges commercial banks for depositing money with it.

The move, adopted by the Bank of Japan last month, is meant to encourage banks to lend money to benefit the wider economy, but the largely untested method can also dent banks’ profits. The EBA has not included negative interest rates in its general scenario for the stress tests, but they are among various market risk shocks that are under consideration, it said.

The EBA said banks would be required to report on their financial strength to national regulators based on their position at the end of 2015, with a report due in the third quarter of this year.