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Europe’s Banks Will Undergo Strict Stress Test

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The European Banking Authority (EBA) announced Friday that the 90 banks that must undergo regional stress testing will have to maintain their core Tier 1 capital levels above 5% during an imagined 2-year recession or they will not pass.

According to Reuters, the EBA has set tougher standards than those it used last year, in an effort to reassure taxpayers. Those requirements are comparable to standards in U.S. private tests, according to the EBA. Although banks in the U.S. that passed strongly were permitted to increase dividends or repurchase shares, European banks are instead being urged to hold their capital.

This is the third round of tests since the beginning of the financial crisis, and in this evaluation, the EBA has said it will exclude much of a hybrid capital instrument that is used by many state-owned banks in Germany because of controversy over its complexity. Instead, the definition of core Tier 1 capital has been set as mainly consisting of common equity and retained earnings.

Qualifying capital instruments are simple, bank-issued, and able to absorb losses. Sovereign debt will not be counted, lest markets react badly to the consideration of a sovereign default; it was not included in last year’s tests either.

The conditions of stress under which banks must maintain capital include conditions common today: economic slowdown, falling property prices and rising unemployment. Another factor considered in the mix is a stock market drop.

New Basel III global capital rules require that banks hold a minimum of 7% core Tier 1 capital as of January 2013, but some countries, such as Britain and Switzerland, have gone farther and will require their banks to hold 10% or even more.