On August 28th the IMF’s new chief Christine Lagarde was bombarded with criticism after she insisted that Europe’s weakest banks need urgent recapitalization in order to curb contagion in the euro crisis. Her main critics were ECB president Jean-Claude Trichet and European Commissioner for Economic and Monetary Affairs Olli Rehn, who countered that Europe’s banks do not need liquidity or fresh capital. However, developments over the past month overwhelmingly support Ms Lagarde’s assertion. In both the peripheral and the core countries, European banks could really be in big trouble.
Mr Trichet and Mr Rehn’s main argument why European banks are reasonably healthy relies mainly on the stress tests that were conducted just over a month ago by the European Banking Authority (EBA). According to these stress tests, only nine out of 91 banks would see their Core Tier I Capital ratio fall under 5% under the stressed scenario. Mr Rehn has repeatedly highlighted that those banks that failed the stress tests are in the process of raising their capital levels by October anyhow. However, the assumptions made in the adverse scenario of the stress tests were a joke. For the most part, the adverse scenario conditions have already come to fruition and in some cases they have been surpassed. Furthermore, the banks did not reveal any of their risk weightings, making the stress test results difficult to interpret.
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