Editorial Board

Europe's Banks Are Still a Threat

The European Central Bank has just published the results of new "stress tests" on European Union banks, hoping to convince financial markets that the banking system is now strong enough to weather another crisis. This latest exercise is a big improvement over previous efforts, which were widely derided as too soft -- but it's still not good enough.

The test had two parts. The first was a detailed examination of loans, to see whether they were worth what the banks said. This found that most of 130 banks under review had overvalued their assets -- by a total of 47.5 billion euros ($60 billion) at the end of last year. The second part asked, with assets correctly valued, whether the banks had enough capital to safely endure another recession and financial-market shock. It found that 25 did not, and 8 of those need to raise 6.4 billion euros in capital, over and above what they've added so far this year.

This closer scrutiny has helped. Deutsche Bank AG raised 8.5 billion euros in equity this year to boost its chances of passing. Weak institutions, such as Portugal's Banco Espirito Santo and Austria's Volksbanken network, are restructuring or shutting down. By strengthening the system and increasing confidence in it, the ECB's tests might reverse a two-year slump in private-sector lending. That's the hope, anyway.

Trouble is, even the new tests were pretty soft. Economists at Switzerland's Center for Risk Management at Lausanne, for example, have put the capital shortfall for just 37 banks at almost 500 billion euros -- as opposed to the roughly 6 billion euros reported by the ECB for its sample of 130. This more stringent test used a method that mimics how the market value of equity actually behaves under stress.

In one way, the ECB had good reason to be strict. It had to contend with doubts aroused by the previous unpersuasive tests. Also, it takes over as the euro area's supranational bank supervisor on Nov. 4, so any lingering issues will be its responsibility. But it knew that if it were too tough, the blow to confidence could have plunged the EU back into crisis. The euro area already has a stalled recovery and stands on the brink of deflation; an alarming report on the banks might have done more harm than good.

So the design of the exercise was compromised. It used a measure of capital that relies on banks to weight assets by risk -- an opportunity to fudge the numbers. It ignored the credit freezes, forced asset sales and contagion that can cause huge losses in bad times. The worst-case scenario projected a fall in euro-area output of just 1.4 percent in 2015 (in 2009, it dropped 4.5 percent). And no governments default.

Most worrying is that the euro area is still poorly equipped to handle any new banking crisis. Many governments lack the fiscal capacity to recapitalize failing banks. Europe's new banking union -- intended to break the link between the finances of banks and national governments -- will have only 55 billion euros in its rescue fund. And there's scant agreement on how the burden of fighting the next financial crash should be shared.

The new tests are a small step forward. They won't dispel the fear that's hanging over the region's banking system and economy.

Corrects amount of capital required in second and fourth paragraphs.

--Editors: Mark Whitehouse, Clive Crook

To contact the editor on this story:
David Shipley at davidshipley@bloomberg.net