ANALYSIS:The stress test aims to provide greater insight into the true state of the banks' affairs

THE LATEST stress test on Europe’s biggest banks marks an effort to undo the mistakes of a botched examination last year, which Irish banks passed only weeks before dire new losses were uncovered.

The exercise is designed to boost confidence by providing greater insight into the true state of the banks’ affairs as the sovereign debt crisis escalates. Whether it succeeds will be seen as analysts work their way through an array of new data on the banks’ holdings and exposures.

As it stands, however, the relatively small amount of new capital they have been told to raise is considerably lower than the worst expectations of investors and many politicians. Although this is an inherently subjective business, many analysts saw reason to doubt the conclusion once it was released.

A total of 90 institutions were examined: eight failed and will require some €2.5 billion in new capital. This is in contrast to expectations that as many as 15 might fail, with investors surveyed by Goldman Sachs expecting a requirement for almost €30 billion in new capital. Credit rating agency Standard and Poor’s suggested in March that banks may need as much as €250 billion.

However, the EU’s new banking regulator, the European Banking Authority, said about 20 banks would have failed if they had not raised capital between January and April. Their shortfall would have been €26.8 billion without the new money, it said. In those four months, European banks raised a total of €50 billion in new capital. Another 16 banks scraped through the test with capital just above the threshold for a pass. The authority has directed them to take action to strengthen their capital.

The test reveals severe weakness in the Spanish banking system, and it shows that Greek banks remains very vulnerable.

This is significant, for Spain is again at the centre of the debt storm and Greek banks are ailing under the strain of an unsparing bailout. No less than five Spanish banks failed and another seven ranked among the 16 on the critical list. Two Greek banks failed and the other bank to flunk the test was in Austria.

Criticism of the exercise centred on the failure to examine the implications of a Greek sovereign default, now a real prospect in one form or another given the overwhelming consensus that the country’s debt is too large to sustain.

That question looms ever larger following confirmation last night that euro-zone leaders will gather in Brussels for an emergency summit on the country’s drastic predicament.

Still, these stress tests go much further than before to reveal the sovereign debt holdings of all examined banks.

It is true that the authority did not examine the implications of any default on the banks’ holdings of sovereign debt in the all-important banking book.

However, by compelling them to reveal the scale and maturity of their holdings of individual countries’ sovereign paper, they opened the door to a more meaningful examination of their position by market analysts.

The authority’s logic here is that it is futile to test publicly the implications of something Europe’s leaders have vowed to prevent. By throwing open the books, however, they have cleared the way for the market participants to make up their own mind.

If the criteria in any single test is as subjective as the next, then the provision of transparent like-for-like information between banks of all nationalities serves to aid rigour and clarity.

In that sense at least, these tests serve to shine more light on the inner workings of the banks. If market investors instinctively question the criteria adopted by the authority, the message from its headquarters in London was that they are now free to run tests of their own based on the data.

These tests are but one moving part in a multifaceted response to the financial crisis and they tell but one part of the story.

We already know what is going on in the political real-time. A French plan to involve French banks in the second Greek bailout is so soft on the banks because they have a big exposure to Athens. With the Greek sovereign holdings of German banks declining, Berlin has pushed for more radical measures to ensure their participation. That says a lot.