Are the latest euro stress tests credible?

Past attempts to test the health of European banks have left investors unimpressed. This time around, it could be different.

Good news from the eurozone. Portugal has followed Ireland out of a three-year debt relief programme, having halved its budget deficit. And the latest bank stress tests from the European Banking Authority (EBA) actually "have some teeth", says George Hay on Breakingviews.

Two past attempts to reassure investors and regulators that banks would not collapse if the economy deteriorated sharply failed completely.

In 2010, regulators' stress tests gaveIrish banks a clean bill of health four months later they imploded. The following year, a Spanish and a Dutch bank that had passed the tests subsequently went bust.

This time round, the tests will be much tougher on sovereign bond portfolios, with a sharper rise in yields planned for. Under the EBA's adverse scenario, there is a 2.1% slide in output over three years, compared to a 0.4% fall last time.

The tests are also "rowing with the tide", notes The Economist. Investors have gradually regained confidence in European banks, which have also made progress on writing off bad debts and raising extra capital.

All very well, as Albert Edwards of Socit Gnrale notes, but it seems "incredibly" complacent for the adverse scenario to assume that the eurozone wouldn't be plunged into deflation, especially considering how close Europe already is to falling prices. This would raisethe spectre of a Japan-style slump.

If deflation arrives, investors' new-found confidence in Europe's banks would be unlikely to last very long.

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