THE FEAR OF STRESS - TEST FAILURE / THE WALL STREET JOURNAL ( RECOMEMNDED READING )

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JULY 21, 2010, 8:17 A.M. ET.

The Fear of Stress-Test Failure

By SIMON NIXON

What is the definition of a failed stress-test exercise? If you're an investment banker, the answer is simple: one that doesn't lead to any lucrative mandates to raise bank equity.

On that basis, the European exercise, whose results are due Friday, looks doomed. Finance ministers from several countries most under scrutiny, including Greece and Spain, have been quick to declare their banking system sound. Any capital raising seems likely to be limited to smaller savings banks that cannot or would not be able to raise public equity and will have to rely on government capital injections instead.

Still, investment bankers are not the type to take "no" for an answer. Unperturbed, some now hope to persuade banks that passed the test to take advantage of any improvement in confidence to bolster their balance sheets. That may be a hard sell, given the European bank sector currently trades on 0.6 times 2010 tangible book value, according to Nomura. No bank would raise capital at a discount to book value if they can avoid it, given the dilution that implies, particularly if they can boost their capital via retained earnings.
Even so, the investment bankers can't be blamed for trying. The challenge is to construct a sufficiently convincing equity story that a decision to raise capital would trigger a rerating to compensate for the dilution. For example, some weakly capitalized banks could use an equity increase to bring forward the resumption of dividend payments. Others could seek to over fund a domestic acquisition, offering investors consolidation synergies as well as a stronger balance sheet. Germany, Spain and Greece, where Piraeus Bank is in negotiations with several smaller players, are all markets ripe for consolidation.

But bankers will be whistling in the wind unless the stress tests lead to improved bank-funding markets. Equity investors won't stump up capital until debt investors start lending again. With European banks needing to refinance an estimated $3.3 trillion of wholesale funding in the coming years, it is to Libor and the iTraxx senior financials index that investors must look for the true definition of stress-test success.

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