TESTING TIMES

Europe stress-tested its banks again—for real this time—and flunked 25 of them

End of the beginning, or beginning of the end? The results of the long-awaited stress test of European banks are out, a comprehensive assessment that will, once and for fall, force the continent’s lenders to come clean about the strength of their balance sheets.

At least, that’s what regulators would like the world to believe. Embarrassed by three previous tests that proved far too tame, European banking regulators, for the better part of a year, have been poring over balance sheets, loan portfolios, and business plans in unprecedented detail. This time, banks that are judged too optimistic in valuing their assets or too complacent in building buffers to shield themselves from future turmoil will not escape the regulators’ wrath.

In the end, the European Central Bank flunked 25 of the 130 banks it tested. (A concurrent test of 123 banks by the European Banking Authority, conducted in concert with the ECB but also including a few banks outside of the euro zone, came up with very similar results.) But since the ECB’s test took the end of 2013 as a starting point, 12 of these banks already have raised enough capital to give them a passing grade.

Under “adverse” economic conditions, these are the 13 remaining banks that the ECB says still need to raise some €9.5 billion ($12 billion) within the next nine months:

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None of these names came as a particular surprise—many already are undergoing deep restructuring with help from their home governments. The aggregate results also are in line with market chatter in the weeks leading up to today’s announcement.

The ECB has always argued that the high-profile test is merely a means to an end. That can be seen most clearly in the headline results—25 banks in 10 countries failed the initial test, but only half of these, most notably in Greece and Italy, weren’t able to reverse their failing grades by building up their buffers in recent months.

The euro zone’s largest banks have added more than €200 billion to their capital buffers since plans for the test were first announced last year. The fear of failure that drove those improvements is more important than singling out a few bad apples for scorn today, officials argue.

Ultimately, the goal is to draw a line under the euro zone’s long-running financial crisis, to promote the confidence necessary to convince banks to reverse the chronic decline in lending that has contributed to the region’s economic malaise.

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The banks that only scraped through today’s tests can’t rest easy, so further improvements should be expected. After all, the ECB says that during its assessment it found a whopping €136 billion in nonperforming loans that weren’t classified as such lurking on bank balance sheets. This new transparency, somewhat perversely, is the best news to come out of today’s tests, according to James Sym, a fund manager at Schroders in London.

Now that the ECB will take over supervision of the euro zone’s largest banks from national authorities, it can apply common, harmonized definitions of asset quality across countries. “We’ll be in a position to compare apples with apples across European banks, which is exciting,” Sym tells Quartz.

Speaking of excitement, it could get choppy when the markets open tomorrow. Spanish banks, which performed a bit better than expected in the tests, and Italian banks, which came out worse, will be under particular scrutiny. Sym, who manages a £300 million ($483 million) European equity fund, is planning an early start tomorrow, and has his eyes on medium-sized banks in Italy and Spain. On these stocks, “I’m prepared to risk perhaps 1% of the fund,” he says. “I want to give myself a 50% chance of doubling my money, and a 50% chance of losing 30%.”

Looking ahead, more fundamentally the stress test could represent a “cathartic moment” for European banks, the fund manager says. “Suddenly, we can trust them.”

If that’s true, it would be a good thing for the rest of corporate Europe, which relies heavily on banks to finance their growth. “If this creates a bit of positive inflection, then that’s pretty interesting for investors,” Sym says. “We’ve already fallen off the cliff in Europe, and you can’t fall off the beach.”

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