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Much like the stress tests that were conducted in the US last year, the stress exercise aims to evaluate the strength of the European Union’s banking sector. Conducted on a bank-by-bank basis by the CEBS and other agencies, the stress tests will determine whether banks can withstand additional adverse financial pressures if things get worse. Ideally, the tests will show that European banks are healthy and restore confidence among investors.
The plan is to expose banks all across the euro zone (including Britain, Denmark and Sweden) to three different scenarios, which I would like to classify, as “bad”, “badder” and “baddest”. In all, about 91 banks will be tested, which should cover about 65% of total banking sector.

In the “bad” level, the capital ratio of each participating bank will tested a benchmark for 2011. The capital ratio determines a bank’s capacity to meet its liabilities and other risks properly. To put it simply, the first test is just a diagnostic test to see if banks could survive the current economic conditions.

At “badder” stage, the stress tests will measure participating banks’ resilience towards adverse financial events.

And finally, at the extreme point when Panda poop hits the fan, they’ll be tested for a “sovereign shock”. In this last stage, they will not assume a total default, but rather, will incorporate assumptions of losses depending on a nation’s debt. For example, Greek bonds are assumed to have a loss of 17%, while Spanish bonds will take a hit of 3%. Banks must also include any write-downs on any assets on their balance sheets.

In addition to these parameters, the tests’ assumptions will also take into account the economic forecasts on both the macro (euro zone wide) and micro (country specific) levels.

If a large number of European banks receive failing marks, it would be a huge letdown since ECB President Jean-Claude Trichet already assured that the results wouldn’t be so bad. Everyone’s who has been bearish on the euro, predicting that the stress tests will reveal a whole new set of problems for the euro zone, will be screaming “I told you so!” while adding to their short euro positions.

On the other hand, if Trichet was right in saying that the stress tests could enhance investor confidence in the euro zone, the euro could breathe a sigh of relief. Euro bulls might keep on charging, resuming their run after yesterday’s strong euro zone PMI reports.

Either way, the results are likely to spark fireworks later on and could also determine the direction of the euro for the next few days. Better stay on your toes!