Colin Barr

Following the money in banking, economics, and Washington

Finding Europe's banking skeletons

July 22, 2010: 4:10 PM ET

We're about to learn where the skeletons are buried in Europe's banks.

European officials are scheduled to issue report cards Friday afternoon following stress tests of 91 major banks. The tests will rate how big banks would fare in another economic downturn.

Time for Eurobanks to show the money.

Bank supervisors and officials at the European Union want to publish the results to ease fears that another banking meltdown is on the way. A similar test carried out last year helped U.S. megabanks raise tens of billions of dollars of capital.

The goal is to end speculation that a bank collapse will add to the economic problems in Europe, which is already struggling with slow growth and massive debt.

"The European debt crisis is not over," said Principal Global Investors chief global economist Bob Baur. "Bank balance sheets are less transparent over there, so doing something to relieve investor worry is a top priority."

The tests will sketch out how banks might fare should Europe lapse into recession, with the understanding that those whose capital drops below a certain level will need to raise more money.

Though the markets have cooled off from their torrid pace in April before sovereign debt worries grabbed investors' attention, they are still healthy enough that many banks that fall short of capital targets should be able to raise funds. Weaker lenders could get infusions from national governments, which are eager to show they are on top of the problem.

"I think these tests should dispel the myth that European governments are too bankrupt to deal with their problems," said Jacob Funk Kirkegaard, a research fellow at the Peterson Institute for International Economics.

But because of the perception that European governments are in over their heads, details will be just as important as overall results.

No one expects the biggest banks, giants such as Barclays (BCS) of the U.K., Santander (STD) of Spain and Deutsche Bank (DB) of Germany, to get failing grades. Their shares have risen since the tests were announced last month, as investors took the news as a sign of government commitment to the banks.

So far, only one bank -- a troubled German real estate lender -- has been reported as failing, in a bit of grade inflation that threatens to undermine the whole exercise.

But the tests could still serve investors, by disclosing which banks are stuck with lots of bonds issued by financially troubled governments in places like Portgual, Ireland, Greece and Spain -- known as the PIGS.

A report this spring said Europe's banks have $254 billion of exposure to public sector debt issued by the PIGS. Knowing just who holds what could help contain fears about the solvency of banks.

"It would be extremely positive for the markets to get information that will allow them to draw their own conclusions," said Kirkegaard.

Ideally, he adds, an unmasking of the Greek debt holdings of European banks could pave the way for a consolidation of the troubled state-backed regional banks in Germany and Spain, which have made such a mess of things in recent years. Germany's landesbanken, for instance, were big losers in the subprime meltdown.

One bailed-out German bank, IKB, stands to recoup $150 million it lost when it played the sucker in a Goldman Sachs (GS) subprime debt deal.

With that history, few would be surprised to see them knee deep in Greek bonds that stand to lose value in what appears to be an inevitable, if not immediate, restructuring.

"Those banks have always been the greater fool," said Kirkegaard.

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About This Author
Colin Barr
Colin Barr
Senior Writer, Fortune

Colin Barr has covered finance for Fortune.com since November 2007. Previously he was a writer and editor for TheStreet.com, winning a 2006 Society of American Business Editors and Writers award for "The Five Dumbest Things on Wall Street," and for Dow Jones Newswires. He is a 1991 graduate of Penn State and lives in Port Washington, N.Y., with his wife Meena Bose and their two kids.

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