WHEN THE EU reruns its stress tests, interested eyes are likely to shift from Ireland to Germany.

Long before the financial crisis, Germany’s state-owned Landesbanks were struggling to be more than just piggy banks for their regional political owners. In pursuit of profits and a reason for their continued existence, many set up subsidiaries in Dublin – often with disastrous results.

Bundesbank figures put the level of exposure by publicly owned banks to Ireland at over €60 billion. Though much of that is believed to belong to the nationalised property lender Hypo Real Estate, the Landesbanks are understood to have considerable exposure investments through their Irish-based subsidiaries.

Considering this, news that all Landesbanks passed last year’s stress tests raised eyebrows across the Continent.

This time around, matters are not so simple. The European Banking Authority (EBA) is demanding EU banks hold over 5 per cent of high-quality capital to pass the stress test to reassure taxpayers that further bailouts will not be required. But it has tightened its test criteria, ruling out the use of German banks’ stille Einlagen or “silent participations”.

These are a kind of non-voting hybrid capital that make up between a quarter and a half of capital reserves in various German financial institutions. Though common in Germany, particularly in the Landesbanks, the EBA shares the concerns that prompted agreement under Basel III for this capital to be converted to traditional equity by 2018.

The EBA is less patient, demanding the banks make the changes now – or risk failing the stress test.

The EBA demand on hybrid capital sparked a frenzy in Germany’s Landesbanks. Aware their already-damaged reputations are on the line, one Landesbank after another hurried to convert their hybrid capital to equity before the April 30th cut-off.

In mid-April, NordLB raised €600 million in fresh capital after the state of Lower Saxony took a majority stake. At the same time, some €1.1 billion of “silent participations” were converted into regular equity capital.

The state government says the investment has been made – and will be repaid – at market rates to avoid the gaze of EU regulators.

Following on its heels was the Landesbank HeLaBa, owned by public savings banks and governments in the central states of Hesse and Thuringia. On April 20th, HeLaBa announced an overhaul of hybrid capital worth €1.9 billion. Unlike NordLB, however, the HeLaBa has found a way to do so without increasing the state shareholdings.

“For now, Helaba’s silent participation will be altered so that it is treated as equity,” said Stefan Löwer, spokesman for the state finance ministry in Hesse. “What effect this will have in the medium term is not yet clear.”

The public bank lobby is convinced the EBA’s capital demands have come too quickly and will cause more harm than good to its members. “We worry that the EBA stress tests sends the wrong signal to markets and doesn’t increase transparency sought by the EBA,” said Dominik Lamminger, spokesman for the Association of Public Banks.

“We’re of the view that the core capital definition should follow current banking regulatory law and cannot anticipate the effect that Basel III will have from 2018.”

The decision not to include the hybrid capital in stress test simulations, leaving the Landesbanken short of capital, arises from concerns the capital, though paid-in, would be of insufficient quality to cover shortfalls in the case of a bank failure. State governments dispute this, seeing the EBA demand as arbitrary and unfair, and have accused Berlin of caving in to Brussels. Officials in Berlin deny that, though admit they would not be unhappy if the stress tests helped along the long-promised reform of the sector.

Officials in Berlin are unsure whether the stress tests will drive on their demand that autonomous state governors “normalise” their Landesbanks. The Landesbanks’ funding problem is tied to their privileged publicly owned status, which means they cannot go to the market and investors for fresh capital. Instead the Landesbanks are reliant on their backers – savings banks and state governments – for equity capital.

Thus, rather than provide another nail in the unwieldy Landesbank sector, the stress tests may in fact copper-fasten the little-loved Landesbank status quo.