Why the European Bank Stress Test is Almost Meaningless

European banks just completed a "stress test" designed to indicate whether a bank could survive a further economic downturn.  The primary measurement in this test is whether the bank is adequately capitalized, another way of saying whether its assets can absorb losses that may occur in such a downturn. Therefore, the definition of capital assets, in this case "Tier 1 Capital," is critical.
The Test
Assume a cumulative two-year probability of a

1. Default rate of 15 percent on property and corporate loans, 
2. 10 percent loss on mortgages and 
3. Stringent "haircuts" (write-downs) on their sovereign debt 

would the bank retain a 6 percent core Tier 1 ratio?
 
Tier 1 Ratio Defined
Included in the European bank stress test's definition of Tier One capital is

1. Deferred tax assets.  These are primarily losses taken by a bank that are in excess of the amount that can be deducted in a particular year, and are carried forward to future years, which cannot absorb new losses
2. Hybrid bonds.  These are loans to the bank that are convertible to common stock, which, again, cannot absorb losses.
3. “Silent participation” stakes, which resemble sovereign debt rather than cash, which has been injected into banks. Nevertheless, it counts this towards its core Tier 1 capital.

Which Banks Would Have Failed Without Using These Items in Tier 1?
According to Reuters, almost all big European banks would have passed.  It's a different story for the
smaller state-owned banks. Germany’s landesbanks, for example, have an average core Tier 1 ratio of only 5.9 percent but a total Tier 1 average over 9 percent, according to KBW. Using a stricter definition of Tier 1 capital would probably mean taxpayers having to stump up much more in the event of an economic decline as described above.

What Was the Purpose Performing the Test Using Such Lax Standards?
Had core Tier 1 capital been applied without including deferred tax assets, hybrid bonds and sovereign debt, the number of banks that would not have passed the test would have been significant enough to cause panic and further economic downturn.

But, by concluding that  only 7 of 91 banks failed the stress test, most people will be reassured that a further European economic downturn won't result in widespread bank insolvency.

Don't bank on it.