Europe's biggest banks must be able to withstand 14-35% house price drops in stress tests, say regulators

Banks will also be expected to show that they could survive a 14% drop in house prices as part of the tests, which are designed to assess banks' resilience to hypothetical external shocks.

The details emerged as the European Banking Authority (EBA) published its common methodology for the tests which will be carried out on 124 banks in the EU. The EBA also published the accompanying adverse macroeconomic scenario document for the stress tests, developed in conjunction with the European Systemic Risk Board.  

The Bank of England has simultaneously announced details of stress tests to be carried out on eight banks and building societies in the UK, designed to measure their resilience to a "very severe housing market shock" and a sharp rise in interest rates. The imagined scenario would see a drop in GDP of 3.5% from its level at the end of 2013, consumer price index inflation rise by 6.5%, unemployment rise by 12% and house prices drop by 35%.

Four of the UK banks to be tested by the Bank of England will also be subject to the EBA stress tests.

The stress tests are part of a range of measures being implemented by banking regulators across the EU as they attempt to gain a clearer picture of the health of the trading bloc's  banking sector and restore investor confidence following the recent financial crisis. The EBA will supervise the tests in conjunction with the European Central Bank (ECB) and national competent authorities (NCAs) in member states. The EBA expects to publish the results of the tests in October 2014.

Banks which fail to satisfy regulators that they could withstand the hypothetical scenarios could ordered to increase their capital reserves.

Following the publication of details EBA chairman Andrea Enria said: "The methodology developed by the EBA for the stress test will ensure a robust and effective tool for supervisors to address remaining vulnerabilities in the EU banking sector. The exercise's full transparency will be key to its credibility: it will show how efforts recently undertaken by EU banks are already bearing fruit and it will provide a common framework for the next steps to be taken by supervisors and banks".

The tests are tougher than the EBA's 2011stress tests, in which it predicted a worst case scenario of a 0.5% fall in GDP, according to the BBC.

The EBA tests outline a hypothetical crisis of confidence in the bond market, exacerbated by lower investment in emerging markets, leading to recessions across the world. In the imagined scenario, the EU's larger economies are assumed to be heavily affected, resulting in national income across the region falling to 7% below baseline projections by 2016.

The stress tests form part of the Comprehensive Assessment being carried out by the European Central Bank, to establish the health of Europe's banks. As part of the assessment, the ECB is currently assessing risk-weighted assets across 128 eurozone banks, at the start of Phase 2 of the asset quality review (AQR) designed to establish a clear picture of European banks' riskier portfolios.

Following publication of the ECB stress test parameters, EU internal market and services commissioner Michel Barnier said: "The EBA has delivered a robust stress test methodology and a tough adverse scenario. In combination with the in-depth asset quality review undertaken by EU banking supervisors including the ECB as single supervisor for the banking union, this 2014 comprehensive assessment will constitute the most intense scrutiny banks have ever faced in Europe. It should dispel any remaining doubts about the health of European banks and their capacity to finance the economy."

After publication of the UK bank stress tests, Mark Carney, governor of the Bank of England, said: "Much has been achieved in recent years to put the UK banking system on a sounder footing, so that it can support the UK recovery. The challenge now is to secure a strong, sustainable and balanced economic expansion. The Bank's annual stress test will help ensure our banks support that expansion by remaining resilient. Today's announcement represents a major step in that new framework."

"Although the events depicted in this stress-test scenario are extreme, and thus highly unlikely to transpire, by bringing together the microprudential standards for banks with a macroprudential assessment of the tail risks to which they must be resilient, the bank is working to ensure that the UK financial system remains one that absorbs rather than amplifies shocks," said Carney.

"Furthermore, this stress test demonstrates the benefits of acting as one bank. The test is the result of close co-operation between the PRA, the FPC, and the macro forecasting units in Monetary Analysis, and also between a range of Bank of England officials and their counterparts across Europe," he said.