David Shilpley writes:  The European Central Bank has just published the results of new “stress tests” on European Union banks, hoping to convince financial markets that the banking system is now strong enough to weather another crisis. This latest exercise is a big improvement over previous efforts, which were widely derided as too soft — but it’s still not good enough.

The test was in two parts.  One found that most of the over 130 banks had overvalued their assets.  The second part assessed whether the correct value of the assets kept the banks in a safety zone.  25 failed the test.  8 needed to raise 6.4 billion dollars.

Deutsche Bank raised 8.5 billion in equity this year to help them pass the stress test. Weak institutions, such as Portugal’s Banco Espirito Santo and Austria’s Volksbanken network, are restructuring or shutting down. By strengthening the system and increasing confidence in it, the ECB’s tests might reverse a two-year slump in private-sector lending.

The tests are pretty soft. Economists at Switzerland’s Center for Risk Management at Lausanne put the capital shortfall at 500 billion euros, not the 6.8 billiioin put forward by the ECB.  Of course, the ECB takes over as the euro areas’s supernational bank supervisor on November 4.  If it had been too tough it might have blown the euro back into crisis.

Economists like Anat Admati would rather have the percentage of equity determine a bank’s ability to withstand stress.

How DId the Bank Pass the Stress Test with So LIttle Cash?