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stress test

A couple walk past a Banca Popolare di Milano bank branch in Milan, Italy, Sunday, Oct.26, 2014.Luca Bruno/The Associated Press

Europe's banks are repairing themselves – even if lenders in Italy and the other countries hard hit by recession continue to struggle.

A landmark exercise designed to improve the health of Europe's post-crisis banks found that 25 of the 130 largest financial institutions failed their stress tests, with a collective capital shortfall of €25-billion ($36-billion) at the end of last year. But many of those banks have since padded out their capital cushions.

The test overseen by the European Central Bank, which becomes the supervisor of euro zone banks next month, and the European Banking Authority showed that Italian banks were the hardest hit, a reflection of the dire shape of the Italian economy, now in its third recession since 2008. Nine Italian banks failed the test.

Among the Italian banks, the biggest hole was found at Monte dei Paschi di Siena, Italy's third-largest bank and the oldest continuously operating bank in the world.

In spite of capital-raising efforts earlier this year, it must still come up with €2.1-billion.

The €25-billion hole was based on data at the end of last year. Since then, 12 of the 25 banks that failed the stress test have raised enough capital – €15-billion among them – to overcome their capital shortfall. That means the 13 laggards need to come up with about €10-billion. Of those 13, four are Italian, two Greek, two Slovenian and one each from Cyprus, Portugal, Austria, Ireland and Belgium.

But of the €10-billion, €3-billion represents a capital shortfall at the Greek banks, whose restructuring has already been approved. So the true capital shortfall figure for all the banks is only €7-billion. In a note, analysts at the French bank Societe Generale called that amount "trivial," given the scope of the exercise.

"Now the ECB needs to get back to the more pressing issue of keeping credit channels open and getting credit demand running again," the analysts said. "Today is a comfort for equity investors but does not soothe the ECB's main headaches.

The banks with outstanding capital shortfalls have two weeks to submit a capital-raising plan, then nine months to actually raise the capital through selling new equity or assets, or a combination of both. If those options fail, the hardest-hit banks probably would have to seek government assistance or merge with a stronger bank.

The capital shortfalls were roughly in line with analysts' expectations – Citi had expected a shortfall of €28-billion.

The number of banks that failed their stress tests exceeded the failure level in 2011 and 2010, when 20 and seven, respectively, did not make the cut, but the latest test was more rigorous than the previous ones. The capital shortfall reported in the latest test is €2.2-billion more than the shortfall in 2011.

Stress tests are designed to identify the weakest banks and push them into boosting their capital cushions so they can withstand economic and financial shocks and not require costly, taxpayer-funded bailouts. In slow-growth Europe, the more pressing goal is to improve the health of the weakest banks, to the point they resume lending to businesses and customers. The lack of credit funnelling into the economy has been in good part blamed for deepening the European recession. The 28-country euro zone is on the verge of a triple-dip recession.

"This unprecedented in-depth review of the largest banks' positions will boost public confidence in the banking sector," said Vitor Constancio, vice-president of the ECB. "By identifying problems and risks, it will help repair balance sheets and make the banks more resilient and robust. This should facilitate more lending in Europe, which will help economic growth."

Some economists doubt the capital-raising efforts will trigger a lending surge. Demand for loans may not rise unless economic growth rises first, giving businesses and consumers the confidence to borrow.

"The recapitalisation and restructuring of Europe's banking sector remains a moving target," said Nicholas Spiro, managing director of Spiro Sovereign Strategy, a London investment consultancy. "If growth doesn't return, asset quality will keep deteriorating and there'll be no revival in lending. This is Italy in a nutshell. It sticks out like a sore thumb after the publication of these results."

Unlike the previous tests, the 2014 stress test began with a check on the asset values of the banks. The review found that lenders' asset values needed to be lowered by €48-billion, though €37-billion of that amount did not lead to a capital shortfall.

The ECB's pass mark was for banks to have high-quality capital of at least 8 per cent of their risk-weighted assets in the most likely economic situation for the next three years, and capital of at least 5.5 per cent under a crisis scenario, in which the banks have to endure a two-year recession and possible market panic.

On Dec. 16, the Bank of England is to publish the results of the stress tests it conducted on Britain's banks.

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