Last week in the markets

Chill-out about the stress tests

By Andrew Webb , 23 July 2010

The results of European bank stress tests loom over a good week for investors.

A good week for stocks was fuelled by strong corporate earnings results even though the strength of the economic recovery remains in doubt. Around a quarter of the largest US firms have reported their second quarter figures so far and the vast majority of them beat expectations. Wall Street gained more than 2% on Thursday as a string of companies pleased investors; and shares in London and across Europe gained momentum through the week to end in positive territory. But the biggest event of the week does not occur until the European markets have closed on Friday when regulators on the continent publish the long-awaited results of their bank stress tests.

"Confidence is high that the sector as a whole will pass with flying colours." Andrew Webb

For months, Europe's banking sector has been weakened by speculation that it is on the verge of collapse. As the biggest holders of sovereign debt, European banks stand to be the biggest losers in the event of an escalation of the problems in that market and with the ongoing repercussions of the financial crisis still providing a stiff headwind, investors' concern is justified. Motivated by a desire to put an end to this speculation, European regulators decided to undertake co-ordinated action to reassure markets of the sector's stability.

That action was to stress test 91 banks across the continent, representing 65% of the total banking sector and at least half in each country. Four UK banks were tested. The stress tests modelled the effect of heavy economic weather and several other situations that could undermine banks' ability to operate. Investors welcomed the openness of the tests, but some have criticised regulators for being too lenient. One critic likened the criteria set by the regulators to running an aeroplane's test flight in a summer rain shower rather than a full-blown storm.

A pass would mean that in the regulator's opinion, the bank is adequately capitalised - that its foundations are up to the job. Failure would come with an instruction to raise capital to shore up those underpinnings.

Confidence is high that the sector as a whole will pass with flying colours. Some individual banks could fail and be instructed to raise funds to boost their reserve capital, but the overwhelming expectation is that the tests will have the desired effect of reassuring investors about the stability of the European banking system.

Since the results of the tests are being announced after the European market has closed, Wall Street will be the first to react to them. Other investors will have the weekend to pore over the detail of the results before expressing their views when the markets re-open on Monday.

A surprising contrast between the recovery in the UK and US economies emerged this week. While the Chairman of the Federal Reserve, Ben Bernanke, talked about “unusual uncertainty” in the US economy and unemployment data there disappointed, preliminary estimates say the UK economy grew almost twice the expected amount in the second quarter – its fastest for four years. The growth was broad-based with the only underperforming sector being transport and leisure which was hit hard by the volcanic ash cloud during the quarter. The pound responded well and gained ground against the US dollar.