Spain worries ease, but new questions on stress tests

Market concerns about Spain's financial health eased on Friday but doubts emerged over a pledge by EU leaders to disclose the results of bank "stress tests" seen as crucial to restoring confidence in the euro zone.

The euro held at a three-week high against the dollar and the risk premium that investors demand to hold Spanish debt rather than German benchmark bonds shrunk back towards 200 basis points after hitting a euro lifetime high of 238 on Thursday.

Spanish stocks also gained, with banking shares leading the way, after a successful Spanish bond sale on Thursday and ahead of a Friday visit to Madrid by International Monetary Fund (IMF) Managing Director Dominique Strauss-Kahn.

But a pledge by EU leaders to disclose the results of tests of whether banks have sufficient capital to cope with financial shocks on a bank-by-bank basis across the 27-nation bloc by the end of July came under close scrutiny.

EU officials have said the resilience tests will apply initially only to Europe's 25 biggest banks and not to smaller institutions, including German Landesbanken and Spanish cajas that are seen as most vulnerable.

A senior euro zone source told Reuters in Brussels on Friday that in a second phase, the tests would be extended "well beyond" the bloc's biggest banks.

But even if that happens, some countries may struggle to force reluctant banks to disclose financial details they would prefer to keep secret. German law, for example, prohibits this.

Pressed on the issue, German Finance Ministry spokesman Michael Offer admitted that there were many outstanding questions surrounding the stress test pledge that EU finance ministers would need to clear up in the coming weeks.

He suggested that Berlin could end up relying on voluntary rather than forced disclosure, saying financial regulator Bafin and possibly the central Bundesbank would need to examine what was possible within the constraints of German law.

"We will do what we think is necessary to restore the confidence of the markets" he said.

It was also unclear what criteria regulators would use to perform the tests. A French official said the scenarios used in tests so far did not include the risk of a sovereign default or debt restructuring in the euro zone.

European Central Bank Executive Board member Jose Manuel Gonzalez-Paramo, speaking in Malaga, said it would be up to individual EU member states to decide whether to publish their stress test results on a bank-by-bank basis.

OBAMA LETTER

The United States has been urging Europe to press ahead with transparent assessments of the health of its banks, a strategy used successfully by the President Barack Obama's administration to restore faith in Wall Street firms in the midst of the global financial crisis in 2009.

In a letter to fellow G20 leaders published on Friday, Obama pressed Europe to do more to address uncertainty over the balance sheets of its banks.

So far, the EU has only conducted a stress test of its entire banking sector, resisting pressure to break down the results by country or bank.

Bundesbank President Axel Weber has urged Europe to proceed with a new set of tests that would include a broader swath of the financial sector and include more drastic stress scenarios.

While such tests could restore investor confidence in many banks, they could also force governments to recapitalise those that remain fragile -- a move that would be highly unpopular at a time when citizens across Europe are facing steep budget cuts.

"In parallel with the publication of the individual results, if necessary, governments will be expected to say what course of action they can envisage" the euro zone source said. "Under no circumstances would a bank that may be under distress be left out in the cold."

The source said the tests would simulate a slowdown in growth and stress on sovereign holdings.

The build-up to Thursday's EU summit had been dominated by concern that Spain, the euro zone's fourth biggest economy, might have to tap a 500 billion euro ($613.2 billion) safety net set up to halt contagion in the single currency area.

Strauss-Kahn met Spanish Prime Minister Jose Luis Rodriguez Zapatero in Madrid on Friday to discuss the economic situation and reforms aimed at bringing down a yawning budget deficit.

Hoping to convince investors they can contain the euro zone debt crisis, EU leaders agreed that countries that fail to meet budget and debt targets will face tougher sanctions in future. They also said budget plans would be submitted to Brussels for review before they are sent to national parliaments.

"The euro zone today is in the middle of the river" Strauss-Kahn told a conference in Italy late on Thursday. "The single currency cannot work without economic coordination and hopefully this crisis will convince governments that coordination is the way forward."