The European stress test that were released today used two scenarios, benchmark and adverse. Assumptions under the two scenarios covered a broad range of elements ranging from economic growth and unemployment rates to commercial and residential property values. The adverse scenario is worse in every category than the benchmark by about 1% in 2011 and 2% in 2012. The economic scenarios were then applied to bank balance sheets, resulting in a hit to capital based on the makeup of each bank’s assets and amount of leverage employed.

Of the 91 banks included in the test, representing 65% of Europe’s bank assets, 7 failed under the adverse scenario, 1 German Bank, 1 Greek Bank and 5 Spanish Banks. Total capital shortfall from the test totaled €3.5 billion. Compared to the US stress tests there results are positive, that is if you believe in the validity of the tests to begin with. 10 of the 19 US banks tested last year failed, resulting in $75 billion in forced capital raising. The US banking system is much larger and top heavy than Europe’s but the disparity between results is still large.

A main concern with European banks is their portfolios of Sovereign debt. A haircut was assigned to each country’s debt to project potential capital problems given another credit scare. The average haircut, which is essentially a drop in price, was 8.5%, highlighted by 23.1% for Greece, 14.1% for Portugal and 12.1% for Spain. Sovereign debt (i.e. the safe stuff) dominates the balance sheets of European banks. This part of the test was pretty realistic in my opinion.

The committee threw in a rate shock scenario into both scenarios. A 125 bps shock to 3-month rates and 75 bps to the ten-year, that’s laughable. I don’t even know why they even did that considering the adverse scenario has 5-year Greek yields going up 500 basis points. If they really wanted to test an “adverse” scenario you’d think they’d get serious about the term structure of interest rates if they wanted to include it at all.

It’s a lot to digest, especially on a Friday afternoon in late July. But at first glance it appears the market likes it. My guess is we’ll know more in terms of individual bank results come Monday morning.

Have a great weekend.