Europe's regulators are still haggling over how tough to be on capital requirements for banks undergoing more stress tests after last year's flopped.
Investors hope a second round of stress tests already under way will clear up worries about which lenders have sufficiently robust capital to withstand economic shocks.
The region's new banking watchdog said on Friday it would apply a stricter capital definition to make this year's exercise more credible, but the exact definition had still not been agreed, preventing it from setting a pass or fail mark.
Europe is attempting to raise the bar on capital just as U.S. banks expect to be told they could be allowed to return cash to investors after a second round of stress tests there.
"It is likely to result in a demand for more capital (from) European banks just as the Fed is telling U.S. banks that some of them are in a position to return capital," said Jon Peace, analyst at Nomura in London. "We have definitely got the U.S. and Europe moving in opposite directions at the moment."
Stress testing of about 90 European Union banks began this month, and on Friday the European Banking Authority published details of the economic shock that will be applied to individual banks and the test's methodology.
Last year banks had to meet a so-called Tier 1 capital requirement of 6% to pass. This refers to a broad measure of a bank's resilience, but lenders can pad it with lower quality assets which obscure how much cash is available to tap.
This year, supervisors will use a stricter 'core' Tier 1 benchmark which should mainly comprise the more robust shareholders' equity and retained earnings.
"There are still a few shortcomings — there is no explicit liquidity test, the sovereign test is done on the trading book only, when most of the assets are in the banking book, and they still have not defined their core capital minimum. It is unlikely to be proper Basel III common equity," Nomura's Peace said.
In a bid to toughen up this year's test, the pass mark will be determined by how much core capital a bank ends up with after applying economic shocks devised by the European Central Bank.
But the definition of this core Tier 1 measure differs across Europe and the EBA has still to thrash out a consensus among national banking supervisors over what counts towards core Tier 1 capital.
Only then can it fix a pass and fail mark.
"We have strengthened the exercise quite considerably. It is important to run a credible test," said Andrea Enria, chairman of the EBA.
GERMAN BANKS ANNOYED
There were also key omissions within the details of the economic shock published by the EBA.
Like last year there will be no stress testing of the sovereign debt banks hold on their banking books — seen as a better indicator of longer-term stability — because governments do not want to spook markets by contemplating even a theoretical sovereign default.
The aim is to reassure investors by giving more precision about how banks would cope with a recession over the next two years. A successful test would force weaker banks to recapitalise and bolster confidence in the stronger lenders.
Last year's test was regarded as a flop after only seven banks failed. All of Ireland's banks passed, despite subsequently needing a massive bailout, resulting in an EU-wide operation to rescue the country from potential default.
German banks may not be able to include within core capital all silent participations, a kind of debt-equity hybrid exclusive to banks there that has been criticised for not being able to absorb losses while a bank is still in business.
"There will be very clear criteria. If an instrument meets those criteria then it will be in. If not, it will be out," Enria said.
Germany's BdB banking association said using core Tier 1 was inappropriate and brought forward stricter global Basel III bank capital rules not due until 2013. The tests must also not spark demands for capital raising, it said.
EBA officials said a pass or fail would not be the final judgement as national regulators may require banks that just scrape a pass to raise capital too. They expect finance ministries to have plans in place before the results come out to show how failed banks on their patch would be recapitalised.
SECOND-BEST SOLUTION?
The U.S. Federal Reserve, which conducted the second wave of tests on U.S. lenders, will allow banks including JPMorgan to lift their dividends after the tests, the Wall Street Journal reported.
Analysts said that could lift U.S. bank shares while the threat of capital raising could weigh on European rivals, potentially widening the premium the U.S. sector trades at.
By 1350 GMT the DJ Stoxx European bank index was up 0.5%, in line with the broader European share market, after earlier easing 0.2%.
EBA officials say investors should have more confidence in this year's test because of what they say is a tougher economic shock and a better review of data to ensure consistency.
The EBA did not list the banks to be tested, saying it had not been finalised. The sample will represent 60 to 65% of EU banking assets, and results will come in late June.
The EBA said there will be enough detailed information published on each bank for analysts to run their own tests.
