Can Europe's Banks Handle Draghi's Exams?

Jonathan Weil joined Bloomberg News as a columnist in 2007, and his columns on finance and accounting won Best in the Business awards from the Society of American Business Editors and Writers in 2009 and 2010.
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The European Central Bank has published plans for its assessment of the euro-area's largest banks. And the signals it has sent are mixed.

To see that, look no further than the ECB's own news release describing its objectives. "The exercise has three main goals: transparency -- to enhance the quality of information available on the condition of banks; repair -- to identify and implement necessary corrective actions, if and where needed; and confidence building -- to assure all stakeholders that banks are fundamentally sound and trustworthy," the ECB said.

The last of those, confidence building, may be at odds with the first, transparency. If it turns out that Europe's banks by and large are in rotten shape, then transparency wouldn't assure stakeholders that they are sound and trustworthy. It would inform the public that they aren't. Plus, how can the ECB be so confident that stakeholders will be re-assured when it hasn't even done the tests yet?

The ECB is running a three-stage probe into the health of the largest banks before taking over supervision of the industry next year. The first part is a risk assessment. The second is a review of the banks' asset quality. The final step will be a series of stress tests conducted with the European Banking Authority.

The ECB's release today included this quote from Draghi: "A single comprehensive assessment, uniformly applied to all significant banks, accounting for about 85% of the euro area banking system, is an important step forward for Europe and for the future of the euro area economy. Transparency will be its primary objective. We expect that this assessment will strengthen private sector confidence in the soundness of euro area banks and in the quality of their balance sheets."

It's hard to know what he hoped to communicate with that last sentence. Does he expect the assessment will boost confidence because he already knows the answers will be flattering? Or does he expect the reviews will be so rigorous and beyond reproach that the markets will accept the results as the final word and move on?

Draghi knows he is walking a tightrope. When pressed during aninterview today in Frankfurt with Bloomberg Television, he said the right things. "Banks do need to fail," to prove the credibility of the exercise, he said. "If they do have to fail, they have to fail. There's no question about that."

Of course some do, if only to prove that the ECB's oversight isn't a joke. And of course Draghi had to say that. The problem with past stress tests by the European Banking Authority is they gave passing grades to large banks thatfailed shortly afterward, such as Dexia SA.

The critical question for the ECB is whether its objective will be to dig out the truth about banks' health and let the chips fall where they may, or whether it hopes to divulge merely the minimum amount of bad news needed to give the results a veneer of credibility.

By telling us ahead of time that the exercise will show banks to be sound and trustworthy, the ECB risks leading the public to suspect the opposite.

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