ECB stress test report on 130 banks in the Eurozone at the end of last week were well-received and widely talked in the market. It is thought to be a good indication for Eurozone economy because among those 130 banks, there was just 13 of them that failed the test; nine banks in Italy, three in Cyprus, and three in Greek. Is that really what it means?

ECB stress test report on 130 banks in the Eurozone at the end of last week were well-received and widely talked in the market. It is thought to be a good indication for Eurozone economy because among those 130 banks, there was just 13 of them that failed the test; nine banks in Italy, three in Cyprus, and three in Greek. Is that really what it means?

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Stress Test

Stress test refers to analysis or simulation on financial institution like banks', or certain high-risk financial instruments', ability to withstand critical economic condition. Bank stress test commonly is done internally by the bank itself to check up on to the bank's resilience at times of crisis. However, since 2007 financial authorities were taking interest in stress test to ensure that the measures are taken in accordance with standard requirement and able to guarantee the country's economic sustainability.

The most well-known stress test are the ones done in the US and EU on their banking sector, but it is actually also done by other countries, like India. The stress test is done by authorities according to a set of predetermined scenario. Banks that is able to withstand well is said to have passed the test, while those that failed will be asked to fix their shortfall until a certain deadline.

One of the basic criteria to pass the test is capital adequacy ratio. Compliance of minimum capital adequacy requirement is important to guarantee bank's liquidity. Banks that lack capital will be hindered in its role to channel credit, and could easily collapse during crisis.

2014 ECB Stress Test

European Central Bank (ECB) held stress test as part of preparation ahead of Eurozone banking supervisory authority takeover by the ECB on 4 November 2014. Part one of 2014 ECB stress test was geared to review asset quality from 130 Eurozone bank's balance sheet per 31 December 2013. The result of the stress test disclosed that 25 of 130 banks failed the initial review, but then 12 banks managed to recapitalize. It left 13 banks behind with total capital inadequacy of 10 billion Euro capital. The 13 banks were given two weeks period to submit their proposal of plans to fulfill the huge shortage to ECB. Meanwhile, European Banking Authority (EBA) that have held stress test toward major banks outside the Eurozone at the same time revealed that banks in the UK, Denmark, Sweden, Norway, Hungary, and Poland have passed the test rather smoothly.

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2014 ECB stress test that is said to be the strictest to date have displayed a somehow more cheerful projection of Eurozone economy, at least better than expectation. With guaranteed liquidity, lending programs too, is hoped to go well. As Deutsche Welle quoted from ECB Vice President, Vitor Constancio, The results guarantee that going forward the economic recovery will not be hampered by credit supply restrictions. Moreover, it gives hope that ECB stimulus packages that aims to push lending will have a good chance to be able to reignate the stagnated economy.

Eurozone Is Still In A Fix

But despite of that, many kinds of ghost still fly over Eurozone. Deutsche Welle also quoted Marce Fratzscher of German DIW economic institute who consider the test as an important partial success. The reason why it is partial is said to be important challenges remain unsolved. The stress test alone will not end the credit crunch for small and mid-sized companies in Southern Europe.

Moreover, the fact that most of the banks that failed to pass ECB stress test comes from Italy makes it particularly worrying. In separate occasion, Hans-Peter Burghof from Hohenheim University told Deutsche Welle, suggested that the fact means Italy is not serious in solving its problems in banking sector, as well as national budget and employment. Further, Burghof said, it will become a major problem for Europe. It needs to be noted that Italy is the third biggest economy in the Eurozone after Germany and France.

Apart from that, stress test are usually only as good as the scenario it was given. As mentioned above, stress test is designed according to a set of scenario; which means that when the circumstances change, so is the bank's resilience against crisis. Deutsche Welle revealed that ECB stress test was done before European sanction on Russia came in to effect, and Eurozone economic prospect might have become worse. Leading global economic media, The Economist, described that 2010 Eurozone stress test failed to detect defects in Ireland two biggest banks, and at just four months later Ireland banking has to be bailed. Stress test in 2011 also passed Brussel-based Dexia, which has to be bailed out for the second time not long afterward.

In the end, although banking health is important, but economic condition is the real thing. In this matter, Eurozone economy is still far from recovery. German Ifo Index yesterday (27/10) dropped from 104.7 to 103.2, lowest figure since January 2013. Meanwhile, September inflation also disappoints, slipped from 0.4% to 0.3%, its lowest since 2010.

For now, ECB stress test might be able to loosen concern on Eurozone economic slowdown, but at the long term, Eurozone prospect is still bleak. Because of that, Eurozone is likely to defend low rate and design more stimulus packages which makes ECB monetary policy outlook and the Fed's points to opposite direction. The Fed is probably going to end its QE program in the FOMC meeting tomorrow, and it probably is not. Regardless, EUR/USD at the long term is still bearish.