Is there a basic flaw at the heart of the bank stress tests? Will Portugal's news just highlight it?
Contagion risk is clear and the real elephant in the room is the banking book sovereign exposures. If these are fudged – yet again – the market is likely to draw conclusions.
Extracts from EBA methodology
The adverse scenario, designed by the ECB, is more severe than the 2010 CEBS’ exercise in terms of deviation from the baseline forecast and probability that it materialises. It includes a marked deterioration in the main macro-economic variables, such as GDP (which falls [actually this is cumulative over the period] four [is this going to be flowed over into the public finances forecast???]percentage points from the baseline compared to three in the 2010 exercise), unemployment, and house prices. The adverse scenario also includes a specific sovereign stress in the EU, leading to further falls in the price of some EU bonds from the already stressed levels seen at end 2010. The sovereign haircuts will apply to positions in the trading book where losses would materialise, and will be accompanied by full disclosure of all relevant [how broad will this actually be????]sovereign debt holdings.
The capital threshold will be focused on a definition of core tier 1 capital which is more restrictive than the tier 1 threshold used last year. The EBA is currently defining common criteria for core tier 1 capital that will be applied consistently across the EU.
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