How Europe Can Save Its Banks

Europe is finally mounting a serious effort to restore confidence in a crippled banking sector that presents one of the greatest obstacles to the area’s economic recovery. Unfortunately, European leaders have yet to provide a good answer to the crucial question: What will they do with banks that are really in trouble?

As it prepares to take on the role of supranational bank supervisor, the European Central Bank has laid out a plan to subject banks to their first truly credible reckoning since the 2008 financial crisis. The three-part effort includes a comprehensive analysis of management and operations, a separate review of asset quality, and a new round of stress tests. By separating the strong from the weak, the ECB hopes to give investors the clarity they need to put their money back into Europe’s financial sector.

Problem is, the ECB’s confidence-building exercise lacks a critical element: The credible commitment of a deep-pocketed authority to recapitalize any banks that are found lacking and can’t raise money on their own. This is what made U.S. stress tests work in the darkest days of 2009, and what has been missing in repeated European efforts to replicate that success.

Without that promise, the ECB’s exercise will be undermined before it even begins. Central-bank officials will know that the discovery of capital shortfalls in countries such as Spain or Italy could spark renewed fears that bailout costs will overwhelm the governments’ fragile finances. As a result, bank examiners will face a strong incentive to hide problems -- a pressure that was on display Oct. 23, when European bank stocks fell after ECB President Mario Draghi said he wouldn’t hesitate to flunk some banks.

Europe’s leaders seem aware of the issue, but their efforts to address it are potentially disastrous. At a meeting this week in Brussels, they’re aiming to agree that individual euro-area governments will prepare plans for resolving or recapitalizing banks that fail the ECB’s tests. This restores the link between bank failure and government insolvency that remains investors’ biggest worry.

The answer is for Europe’s leaders, and German Chancellor Angela Merkel in particular, to move toward the banking union they agreed upon more than a year ago. Most important, this should involve a joint commitment, backed by a common resolution fund, to step in where governments can’t shore up banks that fail the ECB’s test. The more convincing the promise, the more likely private investors will be to provide the needed capital on their own -- and the easier it will be for regulators to impose capital requirements demanding enough to make failures less likely in future.

So far, Europe’s leaders have displayed a shocking insensitivity to the workings of financial markets, forcing them to make policy crisis by crisis. Done right, the ECB’s bank assessments are a chance to stop the next breakdown before it happens. Europe can’t afford to waste it.

To contact the senior editor responsible for Bloomberg View’s editorials: David Shipley at