On Sunday, the European Central Bank announced the results of its health check of European banks, the findings of which have been eagerly awaited by City analysts and traders alike. 
Officially, the health check was known as the Asset Quality Review, or AQR, and saw the bank investigate 130 separate lenders’ balance sheets with a total value of €22trn — a sizeable sum.
In total, lenders across the Eurozone had overvalued their assets by €48bn, leaving a €25bn capital hole, although after including the capital raised by banks this year, this capital hole shrank to only €9.5bn.
Of the 130 banks that were tested, 25 failed, most of which were Italian. Lloyds (LSE: LLOY), Barclays (LSE: BARC) and Royal Bank of Scotland (LSE: RBS) all passed.
Testing criteria
The stress tests were designed to show that banks could withstand a simulated three-year period under stress. During this three-year period, European economic output fell 2.1%, pushing unemployment to 13% and sending house prices down 20% on average. If, after this simulated period, the bank in question had a capital ratio of more than 5.5% then it passed. A bank with a ratio of less than 5.5% failed.
As a result, with only 25 banks of the 130 lenders failing the ECB’s tests, many European investors have breathed a sigh of relief. It seems as if the European financial system is not on the verge of collapse after all.
What’s more, these results clear the air about the state of European banks’ balance sheets, removing any concerns that there could be skeletons hiding in the closet.
So, on an individual basis, what did the ECB’s tests reveal about RBS, Lloyds and Barclays?
The results
Well, Lloyds’s results were easily the most shocking of the group. According to the tests, after a simulated three-year period of stress, the bank’s common equity Tier 1 capital ratio fell to 6.2%, only 0.7% above the required minimum of 5.5%. That said, the bank did point out that this stress test was conducted with last year’s numbers.
RBS performed slightly better than Lloyds. Indeed, despite RBS’ sluggish recovery since the financial crisis, the ECB’s tests revealed that the bank would hold core capital of 6.7% under the adverse scenarios. This result came as a surprise to many analysts, as RBS was expected to be the UK’s worst performing bank. That crown has now gone to Lloyds.
And finally, Barclays, which has been faced with a tidal wave of bad news this year, finally got a piece of good news. The ECB revealed that the bank passed its rigorous set of tests with a core capital ratio of 7.1%, 1.6% above the required minimum.
The bottom line
There’s no denying that the results from the ECB test are revealing. Lloyds’ weak performance definitely surprised many analysts, as on the face of it, the bank appears to have staged a solid recovery since the financial crisis.
But the tests are not over just yet. The Bank of England is conducting its own set of stress tests later this year and these tests will use more up-to-date figures, which should give investors a clearer picture on the current state of the industry.
