In theory, is an exercise where the bank revalues its assets under one or more adverse scenarios in order to find out whether or not it is adequately capitalized.
In simple words, "if things became worse than they are now, do we have enough money (capital) to absorb the losses?"
A prudent banker prepares for the actual stress (not the test) by either reducing the price of an asset (or creating a rainy day account) once collection becomes less than certain. Again, "I think US treasuries are 100% safe so I value their chance of default as zero (no rainy day account). Greece on the other hand, I am not so sure, so I either value the bonds below par or create a rainy day account." If someone doesn't pay, the bank doesn't take the full hit on the day of default since it has provisioned against the loss. Monitoring credits and saving for a rainy day is the very essence of banking.
In Europe, bankers were happily riding the gravy train of buying Greek, Spanish, or Portuguese debt and treating it like German debt (no chance of default). Since the Greek debt paid higher coupons but required no provisioning, this was great for returns as well as bonuses.
At some point early this year, someone realized that the Greek debt was not as safe as its German brethren. Even the rating agencies, never too aggressive to downgrade anything, currently rate Greek debt as junk.
Since most European banks are loaded with Greek debt, the policy makers faced a dilemma vis-à-vis the stress tests: If they used stress prices (current market prices minus a cushion) the banks would show the potential for steep losses. If they didn't perform the tests, the market would continue to distrust the European banks.
The solution? Allow the bankers to decide which portion of their balance sheets would be tested. How? By giving them the chance to book whatever they wanted in a so-called investment account. This would be akin to grade students on just the questions they are sure they know. They can still get a few wrong so, technically, it is still a test.
According to bloomberg :
Yes, you read correctly. They booked 90 percent of the Greek debt in the banking book which means they can price everything at par. One can assume that the rest of the balance sheet was treated in the same way. This, of course, includes not only Spanish, Italian, Irish, and Portuguese debt, but, we may presume, Hungarian mortgages denominated in Euros as well as all sorts of loans to Eastern European companies."Lenders hold about 90 percent of their Greek government bonds in their banking book and 10 percent in their trading book, according to a survey by Morgan Stanley. They have to write down the value of bonds in their banking book only if there is serious doubt about a state’s ability to repay in full or make interest payments."
Unfortunately, the first casualty of this blatant attempt to manipulate public perception of European banks will be confidence itself. Once lost, it will not be easily restored.