Market panic has been creeping from the impoverished periphery of Greece, Portugal and Ireland toward the supposedly heartier core of Europe. Bond yields have risen sharply this month (see chart, right) in Italy, Spain and even France, which until lately has been viewed as second only to Germany as a sound European credit.
The stress test results promise to get full market attention when they are released at noon Eastern time Friday. Scores for Spanish banks, laboring in the aftermath of a massive housing bubble whose collapse left unemployment north of 20%, will get special scrutiny.
But few believe the stress tests will be all that stressful: The adverse scenario for Italian banks includes a yield of 5.9% on 10-year Italian government bonds, notes Nick Anderson at Berenberg Bank -- just a hair above the 5.6% going rate this week.
What's more, the entire exercise will be moot if Europe's policymakers fail to take a more aggressive approach to the debt crisis sweeping the Continent. If they don't stem the panic soon, the banks will come under enormous pressure, regardless of how good they look on paper.
"Italian banks are heavily exposed to government debt, raising concerns that a new phase of the banking crisis could emerge," writes UBS strategist Mike Ryan in a note to clients this week. "This raises the stakes for both elected officials in Italy and policymakers within the EU."
So far, the official response to the problems in Greece and elsewhere has amounted to a variation on extend and pretend. European ministers have started making noises about a different approach -- but progress is slow. Market watchers were hoping for a big announcement out of a European finance minister meeting scheduled for Friday, but that event has now been pushed back.
The delay stands as a setback because analysts' interest was piqued by a Euro group statement Monday pledging readiness to "improve the euro area's systemic capacity to resist contagion risk, including enhancing the flexibility and the scope" of the bailout fund known as the European Financial Stability Fund, or EFSF.
Making the bailout fund bigger and loosening the terms under which it operates could free policymakers to actually cut into Greece's debt load, rather than simply delaying the reckoning.
Germany, which has been stingy on bailouts despite being a major beneficiary of European political union, said this week that euro members can use the EFSF to buy back their own bonds at a discount – a shift that could presage a more long-lasting solution to the Greek crisis.
Germany's flip could point toward a new Greek bailout plan along the lines sketched out last month by Daniel Gros of the Center for European Policy Studies think tank and Deutsche Bank economist Thomas Mayer.
They wrote that policymakers, using an expanded European bailout fund, could end the Greek panic by offering to swap existing Greek bonds for newly issued bailout-fund debt at a steep discount.
The swap would improve Greece's financial position by slashing its outstanding debt, rather than simply extending debt maturities as some previous plans have advocated. It would also leave the EFSF as the Greek government's primary creditor – which would give the fund the leverage to make the debt reduction conditional on further economic reforms.
The Gros-Mayer plan would have the disadvantage of provoking the default that European leaders have taken such pains to avoid. But the authors write that a terminal rating agency downgrade "should be a manageable problem" since it would come in the context of greater clarity of Greece's future.
That may be wishful thinking, and there are those who doubt a Greek debt buyback would actually buy much time for Europe. Jacques Cailloux of RBS writes in a recent report that truly resolving Europe's debt crisis would require member states to fund the EFSF to the tune of 2 trillion euros ($2.8 trillion) -- which isn't exactly pocket change even in the best of times.
Even so, it's clear that any Greek debt plan would mark an improvement on the status quo, as worries about the weaker economies and banks' exposure to them threaten to spiral out of control, regardless of what the tougher stress tests show.
Analysts at Goldman Sachs noted this week that Italian banks themselves appear strong, having completed $14 billion in capital raising. But they warned that "the high degree of interconnection between the Italian banking and other European banking sectors … ultimately implies a relatively high risk that further tensions within the Italian sovereign and banking market could have severe consequences for other countries."
Investors have had their eyes on the results of the new, stricter stress tests ever since the ones last year failed so miserably to quell market fears about the strength of Europe's banks. That effort foundered when Irish banks passed the test, only to require tens of billions of euros in new bailout money just months later.
The hope is that the second time round will be more useful -- though that is ultimately up to the guys who run the euro zone.
"All bets are off if Spain and Italy are included in the debate," says Anderson. "Until the market sees a credible solution to the debt crisis, there will be no sustained" banking sector rally.
And no end to Europe's summer of stress.
