Europe's banks have been told to put a figure on potential losses from holdings in Greek and other government debt. This is aimed at ensuring that a health check of banks realistically reflects the deepening euro zone crisis.
Reuters quoted sources involved in the EU stress test of 91 banks as saying that regulators are 'tightening the thumb screws' on banks to spell out the impact of a government debt default - but without having to make the politically unacceptable assumption in the test that a default can happen. Test results will be published on July 13, the sources added.
Until now fallout from the sovereign debt crisis was focused on a bank's day-to-day trading book, but most government bonds are held on a bank's core banking book.
The disconnect has become even starker as the euro zone debt crisis worsens, giving regulators a bigger headache as they try to avoid another stress test flop.
The test is aimed at shoring up investor confidence in the sector which is already being hit by the prospect of tougher regulation eating away into profitability.
After last year's test flopped - Irish banks had to be bailed out after passing - the fledgling European Banking Authority (EBA), which is conducting the tests, is staking its reputation on delivering a credible exercise this time round.
Europe has raised the bar for banks this year, demanding they hold more, better-quality capital to withstand a possible two-year recession.
A German regulatory source said the EBA had tightened the screws to draw up the 'harshest version' of haircuts or losses on government debt.
The estimated banking book loss would be based on the probability of default (PD) and loss given default (LGD), as with estimates of credit risk for all banking book assets, sources said.
The probability of default is based on a sliding scale of credit ratings from Moody's and Standard & Poor's from June 1. Both the PD and LGD indicators have risen sharply for Greek bonds in recent weeks.
The EBA's tougher approach looks at how a bank would survive a four-notch rating downgrade to low rated government debt holdings - a move that would take Greek bonds into default territory.
