A proper acid test for Europe's banks

The moment of truth for the eurozone is drawing nearer as the European Central Bank prepares to take over responsibility for supervising the region’s banks late this year.

Before that occurs, in November, the ECB will conduct risk assessments, asset quality reviews and stress tests of the 130 or so of the eurozone’s largest banks. Previous stress tests by the European Banking Authority generated cynicism and were regarded as more of a cosmetic exercise to shore up confidence in European banks than the rigorous exercises that have been conducted in the US.

The ECB, which will want to protect its own credibility as a supervisor, is expected to adopt a tougher approach than the EBA. The transfer of supervisory authority is the key plank in the proposed eurozone banking union, which is designed to try to break the nexus between under-capitalised banks and their over-leveraged national governments.

That makes the various reviews and tests the ECB will conduct a potential flashpoint for a eurozone which, while economically weak, has at least been relatively stable since the ECB’s president, Mario Draghi, made his extraordinarily effective and calming ‘’whatever it takes’’ comment 18 months ago.

A key issue for the ECB reviews will be how it treats bank holdings of government bonds. In the EBA tests, sovereign debt was (for obvious political reasons) treated as a risk-free asset class, despite the evidence provided by Greece and others to the contrary.

The ECB has said it will stress test holdings of government bonds but appears to be leaving it to the Basel Committee on Banking Supervision to decide how much capital, if any, the banks should hold against them.

The issue is a potentially critical one. In 2011 the ECB injected more than $1.5 trillion of three-year funding into the eurozone’s banking system in an attempt to promote greater lending and economic growth. The banks, however, used the funds primarily to buy their own governments’ bonds.

One of the most destabilising aspects of the crisis that enveloped the eurozone post 2008 was the inter-connection between banks and their governments, with governments using emergency funding provided by the ECB to inject liquidity into their banks and the banks using the funding to buy sovereign debt to try to lower their governments’ funding costs and perceptions of risk.

Breaking those linkages will be a delicate and potentially dangerous process but one that has to be undertaken at some point if the eurozone’s vulnerability to renewed crisis is to be reduced.

The relative calm within the eurozone since Draghi’s remarkably effective ‘’jaw-bonding’’ has given the banks time to raise capital and shrink their balance sheets, so the threat posed by a rigorous ECB examination of their condition ought to be lower than it once was.

The continued weakness of the eurozone economies, particularly those within southern Europe, however, means that isn’t a foregone conclusion. The percentages of non-performing loans in economies like Italy and Spain has been rising and there have been concerns expressed that the public data understates the true position. A requirement for banks to hold capital against sovereign bonds would add another dimension to their capital requirements.

The ECB tests are part of a process under which the eurozone is moving towards a banking union which will include a single resolution board for dealing with failing banks and the creation of a fund to assist in responding to banks with problems.

Under the proposed single resolution mechanism private equity holders and creditors would be ‘’bailed’’ into any rescue or wind-up of a failing bank, taking the first hits before national or eurozone funds could be called on. That was how the bail-out of Cyprus was undertaken.

That points to a transitional challenge that may arise if the ECB tests reveal the need for large-scale capital raisings by the banks.

Why would private investors supply capital to the weakest institutions and why would debt providers not be panicked if the ECB tests identify institutions with significant shortfalls of capital? Would the governments with the weakest banking systems have the resources to recapitalise their banks?

The path towards a stable eurozone banking system is fraught with potential dangers and obstacles and the temptation to find ways to continue to do what the Europeans have done for the past five years and muddle along, deferring the difficult decisions, will remain.

The ECB’s reviews and tests will provide some insight into the extent to which the eurozone authorities are determined to finally address one of the key structural issues in the union, the relationship between under-capitalised banks and their governments.

If the banks can get onto a sounder footing and at arms-length from their governments, it would be easier (but not easy) for the authorities to then focus on the even larger issue of sovereign debt levels within the weakest economies in the context of a single currency zone.