IMF Urges More Forceful Action to Repair EU Bank System

The European Union needs to take “more forceful action” to shore up its damaged financial sector, including targeted asset-quality reviews to make sure banks aren’t hiding further problems, International Monetary Fund staff said in a report today.

From French banks with big cross-border exposures to vulnerable German savings banks, Europe’s banking industry faces risks that mean it should press ahead with efforts to build a banking union, the Washington-based IMF said in its first assessment of financial regulation across the 27-nation bloc. The report said “pockets of weak banks” continue to threaten hard-won progress to restore financial stability.

“Moving banks and sovereigns jointly to safety is essential,” the IMF staff said. “This should be accomplished by policy contributions that strengthen banks without weakening public-sector balance sheets or vice versa.”

EU leaders decided last year to create a common euro-area bank supervisor at the European Central Bank as part of efforts to contain the sovereign debt crisis. The EU also raised the prospect of offering banks direct aid from the euro area’s 500 billion-euro ($653 billion) firewall fund as a way to break the cycle of banks and nations exacerbating each others’ woes.

The IMF urged the EU to meet June targets for designing rules for the ECB supervisor and on how banks can apply for direct aid. It also warned that if not well planned, the ECB’s oversight could be hampered by individual nations or conflicts from the central bank’s main policy goals.

‘Not Optimal’

“There is a risk of conflicts of interest between the monetary policy function and the supervisory function,” according to the report. “Given that the ECB Governing Council must pursue its primary objective of price stability, it may take decisions that from a supervisory perspective are not optimal.”

EU leaders also have set a June deadline for governments and the European Parliament to agree on legislation that sets out how authorities should handle bank failures. In the absence of such a system, the bloc’s nations have injected 1.7 trillion euros into their banking systems since the 2008 collapse of Lehman Brothers Holdings Inc., according to European Commission data.

“Risks remain elevated, especially in a context of low growth and fiscal retrenchment,” the IMF’s executive board said in its response to the financial stability assessment. The board underscored the report’s call for nations to coordinate bank oversight and find ways for banks to repair their balance sheets and reduce reliance on wholesale funding.

Bank Resolution

In the staff report, the IMF renewed its call for the EU to press ahead on bank resolution at the same time that the new supervisor takes effect. It urged the EU to create a toolbox, rather than a rigid regime, and it warned that efforts to put creditors in the firing line for losses could fall short of expectations because “only a handful of banks have so far made progress in raising liabilities subject to bail-in” when a bank fails.

The European Banking Authority’s next round of EU bank stress tests will examine lenders’ preparations to meet international bank capital rules, the IMF said. The requirements, known as Basel III, are scheduled to take full effect in 2019. These reviews are likely to involve three-year projections of banks’ reserves “under a baseline and a stressed scenario,” according to the IMF report.

Once the ECB is given bank supervision powers, the EBA should continue to coordinate stress tests, the IMF said. Regulators also should develop further stress testing to monitor liquidity “while safeguarding sensitive results” to avoid spooking markets, the IMF said.

Previous rounds of the EU exams, and a separate capital-raising exercise that the EBA began in 2011, have failed to fully restore confidence in the bloc’s lenders, the IMF said, “in part because the market suspects some banks of having been insufficiently transparent” about “their losses and exposures to problem sectors.”

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