The results of the European bank stress tests are due this Friday. In addition to having company-specific ramifications for EU banks, they will also be extrapolated as an indicator of the health of the overall EU banking sector.

Understanding the goals, risks, and themes going into these results provides an opportunity for investors to prepare and position themselves accordingly ahead of the event and react from a more informed perspective upon their release.

The Test

The European Banking Authority (EBA) will release the results of its latest stress test on July 29. The results include the 51 banks with a minimum of €30 billion in assets, covering ~70% of the European banking sector.

The test is based on banks’ year-end 2015 numbers, using a static balance sheet assumption and the stressed scenarios are applied over a three-year period from Q1’16 to end-2018, calculating capital level each year.

Banks will be tested under two scenarios; baseline and adverse, in line with the 2011/2014 bank stress tests. The EBA will provide the baseline scenario and the ESRB is responsible for designing the adverse scenario.

The EU said that its autumn 2015 forecast provides the baseline macro scenario through 2017 for most variables and the 2018 baseline was derived for the purpose of this exercise and isn’t part of the official forecast.

Methodology

This year sees the removal of capital hurdles, which means no explicit pass or fail grade and a reduction to 51 banks from 123. Banks from Portugal, Cyprus, and Greece are considered too small to be examined this time around.

The stress test will use common methodology to assess solvency and covers all main risk types. The results will be used to inform the Supervisory Review and Evaluation Process (SREP) to determine banks’ health.

The SREP is designed to identify if a lender is failing, or could it fail if market conditions change, and it evaluates; credit risk and securitization, market risk, sovereign risk, funding risk, and operational and conduct risks.

The immediate focus will fall on capital; EU law sets a minimum CET1 requirement of 4.5% for banks within an 8% basic requirement for Tier 1 and Tier 2 capital and banks also have to comply with buffer requirements.

The Italian Banking Industry

Notably, the results of Italy’s lenders are likely to cast the spotlight on troubles in the country’s banking system, sparking political volatility ahead of the government’s referendum on constitutional reform later this year.

Particular focus is likely to center around Monte dei Paschi di Siena, which is vulnerable given its €47 billion pile of non-performing loans (NPL) and the third largest of the nation’s lenders.

European-banks-stress-tests-italy

Preliminary data cited by press indicates that Monte dei Paschi di Siena’s capital is at risk, but Intesa Sanpaolo, Banco Popolare, UBI, and UniCredit all show resilient capital levels under stressed scenarios.

There’s likely to be ongoing focus on how the results of the test determine the contentious issue between Rome and Brussels of bank bail-ins given Italy’s outsized retail investor base/exposure to subordinated debt instruments.

Related: Bracing for the Next Brexit

Italian officials have denied the need for bail-in of bondholders in local banks, stepping up efforts to top the country’s bank rescue fund Atlante by raising capital from private investors instead of a government bailout.

Latest reports suggest Monte dei Paschi di Siena has asked at least eight banks to guarantee a €5 billion cash call in order to comply with demands to strengthen its balance sheet, the bank is also seeking ECB approval to sell NPLs to the Atlante fund.

Other Notable Risks

There’s also been focus on Western European lenders, particularly German, following restructuring efforts at Deutsche Bank and Commerzbank this week that revealed a weakened capital position.

Nordic and Scandinavian banks could reveal exposure to housing market debt due to negative rates generating a housing bubble in Sweden, and diminishing net interest margins.

Other lenders in the region could also be exposed to weak shipping and offshore markets, which triggered higher loan losses in recent earnings results for banks like Royal Bank of Scotland and DNB.

According to reports, Spanish banks Santander, BBVA, Bankia, CaixaBank, Sabadell, and Banco Popular will all pass with comfortable capital ratios.

There are also concerns that UK banks will reveal fresh vulnerabilities following the Brexit vote, which has driven up a notable level of growth uncertainty, despite all banks passing the BoE’s stress test last year.

Primarily, the bulk of the risk center around the Eurozone’s anemic growth performance and the ECB’s lower for longer/negative rates policy impacting profitability across EU banks, together with huge amount of NPLs.

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