Two main features, aiming at reassuring the market, distinguish this year’s tests from the 2010 exercise:

• A stricter methodology involving more stringent risk scenarios.

• The publication of significant additional data relating to the banks, in particular sovereign debt and interbank exposures by country and maturity.

Further reassurance is being offered by the commitment of national Governments to support any bank failing the test.

Chances are, however, that the publication will raise more questions than provide answers. Additional volatility is to be expected in the coming days.

The first reason is that there is little evidence that anything concrete is being done to address the core issue of the excessive interdependence between bank solvency/liquidity and sovereign debt exposures. The additional data published on bank sovereign exposures will therefore encourage the market to derive its own second layer of test results, integrating the additional information. Being carried out on a decentralised basis, conflicting interpretations of this second round analysis are to be expected, creating further uncertainty.

A second reason is the lack of clarity surrounding the commitments of individual governments to “support their banks”. It is quite obvious that this undertaking is of a totally different nature when applied, say, to Ireland or France:

• The credibility of Ireland to “support” its banks (which was imposed in the conditionality of the first EU/IMF rescue package mandating a banking sector recapitalisation of €35billion) must be evaluated in light of Ireland’s own ability to avoid a restructuring of its sovereign debt. Indeed, any such restructuring has dramatic implications due to the significant holdings of Irish debt by Irish banks (this applies mutatis mutandis to Portugal, Greece, Spain and Italy).

• The credibility of France’s support depends on whether, in evaluating the exposure of its national banks to other EU banks, it considers that these are fully secured by their respective government’s commitments, which is obviously doubtful for exposures to banks in the PIIGS countries.

It will therefore be of great importance to clarify whether, for instance, in evaluating the resilience of BNP or Credit Agricole to stress, one assumes as a “credible given” that Italy will “guarantee” the solvency of its banks (as required from Ireland) and that, consequently, no material credit risk is being incurred. My hunch is that markets will reject such a benign interpretation.

To avoid confusion, healthy Members States should clearly extend their support of domestic banks to cover both their foreign EU bank and sovereign exposures. This means that if, say, a French bank incurs losses on such exposures, it is the responsibility of the French government to intervene and recapitalise, merge or otherwise liquidate in an orderly fashion its troubled institution.

Failure to remove any doubt as to the robustness of the undertakings of governments (one needs both belts and braces) will lead to further market disruption, as rating agencies and operators put the “worst” interpretation on possible outcomes.

There is a small window of opportunity for governments to manage rather than to react to the impact of the EBA release of the stress test results. Let us hope it will not be squandered.

Brussels, 15th July 2011

Paul N Goldschmidt

Director, European Commission (ret); Member of the Thomas More Institute.