Europe's Goldilocks moment

Is it too cynical to suggest that the results of Europe's stress-testing of its banks are likely to produce a 'Goldilocks' outcome on Friday – not too dire but also not too obviously fabricated or manipulated?

If the Americans were able to 'manage' their stress-testing last year to produce an outcome that reassured, why can't the Europeans, who tend to regard Americans as unsophisticated, be able to do the same?

Everyone, including our own Reserve Bank (in its latest board minutes), says it is critical the European tests be regarded as credible and that there are plans in place to deal with any capital shortfalls they identify. Similar things were said in advance of the results of the US tests being released.

It is worth noting that stress-testing is more art than science. It involves using broad scenarios – in Europe's case, a significant slowdown in economic activity over the next two years and further steep falls in the value of government bonds issued by the weakest of the European economies – and then evaluating the capacity of individual institutions to absorb those stresses.

In the US tests, there were two dimensions involved in the calculations: the adverse changes to the external settings and the measures individual institutions could take to respond to them, which included assumptions about prospective revenues, asset sales, balance sheet growth and internally generated capital.

In Europe, as my colleague Karen Maley has noted, the testing of two-thirds of the European banking sector isn't being done by a single regulator or group of regulators but by individual regulators in 27 countries using, it is said, different methods and processes. That adds further 'flexibility' to the testing process.

The US tests of the 19 biggest banks concluded that nine had no need to raise new equity and the other ten required $US75 billion of additional capital as insurance against a deeper and longer economic downturn.

That was a number big enough to reassure the markets that the testing was rigorous and credible – but well within the capacity of the banks concerned, who quickly raised the capital, with or without government help. Stresses were relieved and markets calmed.

It subsequently emerged that in the weeks leading up to the release of the results the banks had been negotiating with the Federal Reserve and had succeeded in substantially scaling back the size of the capital requirement flowing from the tests.

The Wall Street Journal reported at the time that Citigroup's deemed extra capital requirement had been scaled back from $US35 billion to $US5.5 billion and Bank of America's from $US50 billion to $US33.9 billion as a result of their discussions with the Fed.

The framework within which the European tests are occurring is somewhat different – the European economy is in worse shape that the US economy was last year and there is a fear of European sovereign debt that wasn't an issue for the US banks – but the basic challenge is the same.

To calm markets and allay fears the tests have to show that, yes, there is a problem with some banks, preferably not those of systemic importance, but that the problem is manageable and will be quickly managed.

A number of the European countries, including Spain and Greece, have set up or are in the process of establishing emergency support funds for their banks. The European Union's emergency loan program and the European Central Bank's capacity to buy sovereign and bank debt are also backstops.

Provided the disclosed problems and new capital requirements aren't too daunting – and there is sufficient discretion and subjectivity in the testing process to ensure that they aren't – the Europeans ought to be able to handle the remedial actions required.

Ultimately what matters is confidence in the systemically important institutions – the big banks – and the shoring up of their own confidence in their peers so that they resume dealing with each other and re-open the European inter-bank market. Second and third tier institutions which can't raise sufficient capital can be bailed out, merged or even allowed to fail if that were unavoidable.

The US experience suggests that if the European authorities can convince the markets that the test results are credible it can be something of a turning point, with self-reinforcing effects on the health and stability of the banking system.

They would have known when they started the process that Europe couldn't afford an outcome too big and bad to deal with. It's one of those questions that isn't asked unless the answer is known with a reasonable degree of confidence – or the elements that produce the answer can be finessed to produce the 'right' outcome.