Europe will stress test its banks again, and this time it really means it

Welcome to the house of pain.
Welcome to the house of pain.
Image: Reuters/Ralph Orlowski
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New bosses often get all of the bad news out of the way as soon as they arrive, lest they are blamed for their predecessors’ failings. And so it is with the European Central Bank, which is slated to take over direct supervision of the euro zone’s largest lenders next year.

The ECB published its rules for a comprehensive “asset quality review” of the region’s banks today. The review will start in November and cover around 130 banks with assets worth 85% of the euro zone’s banking industry. These banks will also face a stress test—a review of whether their capital cushion is thick enough to withstand a souring of loans during a hypothetical economic downturnby the European Banking Authority around the same time, with the final results published in October next year.

Officials say that a thorough examination of the darkest depths of banks’ balance sheets will draw a line under the euro zone’s long-running financial turmoil. But haven’t we heard this before? Yes, several times. Banks have been subject to a battery of examinations since the financial crisis, by EU officials as well as national regulators, each exercise purportedly tougher than the last. And yet banks with passing grades later ran aground, assumptions of “stressed” conditions prove too weak, and estimates of capital shortfalls too modest.

What will be different this time? For one thing, the ECB is now involved, and its president, Mario Draghi, says he’s unafraid to give banks failing grades. The ECB’s review will also poke around in the recesses of banks’ balance sheets where previous stress testers failed to tread. Stricter definitions of capital and common definitions of non-performing loans, restructured debt and other areas open to interpretation will give the tests more credibility. Banks are already complaining about the new standards, a sign that they might actually have teeth.

Draghi’s Catch-22

Still, there is a weary sense of déjà vu among euro watchers. In banking reform, as in so much else, the capacity for European institutions to fudge difficult decisions is formidable.

And while the ECB needs to get tough on banks if it is to be their regulator, there’s a risk that it will get tough too quickly. ECB supervision is only the first step towards a fully-fledged banking union, in which euro-zone banks are backed up by shared deposit insurance and a common rescue fund, instead of the current patchwork of national systems. If the ECB identifies big holes in banks’ balance sheets before these other crucial planks of a banking union are in place—and if any banks can’t fill those holes from private sources, whether by raising fresh equity from shareholders or by bailing-in bondholders—the result may be to pile more debt on sovereigns’ already stooping shoulders.

So while an honest reckoning of the health of the euro zone’s banks is long overdue, there is a risk that by acting too tough, the ECB could wreck the system it is meant to save.