EU watchdog sets tough 2011 bank stress test

* 88 euro area banks, 65% of bank system

The European Union's powerful new banking watchdog is setting out a tough fitness test for the region's lenders to ensure they can withstand future financial crises, documents from the watchdog showed on Tuesday.
The European Banking Authority (EBA) is conducting "stress tests" on 88 EU lenders holding 65% of the bloc's total assets over the coming months to see how well banks would hold up in a severe economic crisis.
"This adverse scenario is similar to those developed for EU-wide stress tests in 2009 and 2010," the EBA wrote in documents sent to banks to prepare for the test, a copy of which was obtained by Reuters.
"It is composed of three elements: a set of EU shocks — mostly tied to the persistence of the ongoing sovereign debt crisis, a global negative demand shock originating in the U.S. and a U.S. dollar depreciation vis-a-vis all currencies," the EBA said.
The EBA, launched in January with powers to impose binding standards on member states, is being watched to see how credible this year's test will be in restoring confidence into a sector that still depends on government support in some cases.
The adverse scenario includes a 0.5% economic contraction in the euro area in 2011 and a 15% drop in European shares, the documents showed.
For the first time, the scenario will also take account of a rise of 75 basis points in long-term yields for euro-zone government bonds and a sharp decline in the real estate market.
Increased tensions in wholesale funding markets, leading to a 125-basis-point increase in short-term interbank financing costs, will be simulated as well.
The test will also include a scenario that foresees euro-zone GDP contracting by another 0.2% in 2012.
The EBA will also test a global demand shock emanating from the United States and the effect of a 4% U.S. dollar depreciation.
As expected, the test will not include assets held in lenders' bank books, allowing periphery sovereign bonds classified as held until maturity to escape the same writedowns impacting their trading book under the test's scenario.
EBA Chairman Andrea Enria told Reuters last week that this year's test would be much tougher and that the new authority's own credibility depended in part on a successful outcome.
Last year 91 banks were tested and only seven failed, none of them from Ireland whose banking sector the EU and International Monetary Fund had to bail out later.
Since Europe's banks were found in need of only 3.5 bln euros in fresh capital, the stress test was widely viewed as far too lax, mainly since it did not look at the bank book.
On Monday, Moody's highlighted euro zone risks when it downgraded Greece by three notches to "B1", on par with frontier sovereigns such as Vietnam, Bolivia and Albania. It said the likelihood of a Greek default or voluntary distressed debt exchange had risen.
Final criteria for the stress test are due to be published on Friday, March 18.