It will be interesting to see how well Italian banks handle stress tests later this year given new S&P; capital shortfall estimates.

Of course, the stress tests were watered down twice already, and if need be I am sure ECB president Mario Draghi can find additional ways to further dilute the tests.

Yet, whether or not the losses are hidden, they are real. S&P; warns Full recovery a long way off for Italian banks

Italian banks will need to set aside as much as 42 billion euros ($57 billion) in new provisions for credit losses by the end of 2014 and some may have to raise additional capital, rating agency Standard & Poor’s said on Tuesday.

It said a full recovery for the sector, which was badly hit by the euro zone debt crisis and is struggling with rising bad debts, remained a long way off because of Italy’s weak economic prospects and continued deterioration in asset quality.

S&P; expects the stock of bad loans at Italian banks to rise to 310 billion-320 billion euros by the end of this year, or about 18 percent of customer loans.

That will force the lenders to set aside an additional 32 billion-42 billion euros to cover for credit losses between June 2013 and December 2014, according to the agency’s estimates. Combined loan loss reserves stood at 111 billion euros at the end of June last year.

“The large stock of NPAs (non-performing assets) is likely to remain a burden for Italian banks as a protracted economic recovery and rising unemployment could lead to further asset quality deterioration,” S&P; said in a report.

History suggests the rating agencies are rather conservative when estimating such losses. Thus, I expect shortfalls to be much bigger than estimated, especially given the overly rosy estimates of a European recovery that is realistically nowhere in sight.

Mike “Mish” Shedlock