Europe needs more than 'healthy' banks

Despite ‘positive’ results from the ECB’s bank stress test, the region remains on the brink of its third recession in six years.

Twenty-five banks failed the European Central Bank’s stress test released on Sunday -- almost one in five of the 130 banks tested -- and collectively they fell short of the minimum level of capital necessary to withstand a crisis by €24.6 billion.

The results are not as poor as they first appear, since progress has already been made and most of the banks that failed are smaller entities, but the report doesn’t offer many reasons to rejoice either. The truth is that no matter what position euro banks are in, the region and the financial sector will remain in a state of financial crisis for the foreseeable future.

An asset quality review (AQR) provided a starting point for the stress test and required banks to have a minimum Common Equity Tier 1 (CET1) ratio of 8 per cent. Tier 1 capital largely consists of shareholders’ equity and reserves such as retained earnings.

The ECB then ran two scenarios -- a baseline and adverse scenario. Banks were required to maintain a minimum CET1 ratio of 8 per cent in the baseline scenario but under the second scenario, that was relaxed to 5.5 per cent.

Under the adverse scenario -- during which the euro zone economy shrinks 7 per cent below the current outlook and the unemployment rate rises to 13 per cent -- the CET1 ratio for the median participating bank declines by 4 percentage points to 8.3 per cent in 2016. As noted earlier, 25 banks failed the stress test resulting with a capital shortfall of €24.6 billion.

The failures were concentrated within Italy (nine failures), while both Greece and Cyprus had three failures. No major banks failed the test.

It’s also important to note that 12 of the banks which failed have already taken steps to cover their capital shortfalls by raising €15 billion in new capital.

Yet it is difficult to be too optimistic about these results. Sure, many euro zone banks have taken significant steps to improve their capital position but the euro zone stills sits on the verge of crisis, on the brink of its third recession in the past six years.

Furthermore, the ECB has received widespread criticism over previous stress tests, which passed several banks who later had to be rescued by governments when the going got tough. Unfortunately, this stress test can only be viewed as credible after the fact -- when it’s no longer relevant.

The ECB, however, remains optimistic.

“This unprecedented in-depth review of the largest banks’ positions will boost public confidence in the banking sector,” said ECB Vice-President Vítor Constâncio. “By identifying problems and risks, it will help repair balance sheets and make the banks more resilient and robust. This should facilitate more lending in Europe, which will help economic growth.”

There’s no doubt that a well-functioning financial system would serve the euro zone well, but it remains but one piece of the puzzle. More pressing is the chronic lack of domestic demand, which has only been hampered further by austerity measures, structural imbalances, German stubbornness and the fear of deflation.

As a result, don’t expect the stress tests to provide the boost to confidence that the ECB is desperately hoping for. The problems in the euro zone are so vast that it will take years before their financial system and economy operate effectively -- if it ever happens at all.

Another event scheduled for later this week is set to have a much larger impact on the future of the euro zone than the banks’ stress test. The French and Italians are set to test the future of austerity on Wednesday when the European Commission offers a verdict on their budget for 2015.

Austerity has proven devastating for so many countries in the euro zone and yet the fiscal benefits have yet to materialise. Gross debt rose to 95.2 per cent of nominal GDP in France during the June quarter and has increased by 2.5 percentage points over the year.

In Italy, gross debt is at 133.8 per cent of nominal GDP and has increased by 5.5 percentage points over the debt. The narrative across the broader euro zone is hauntingly similar.

Italy has shown a willingness to work with the European Union and present a budget that contains a sufficient -- though still inadequate -- decline in their structural budget deficit. France has shown no such inclination and a long overdue showdown appears inevitable.

It would be easy to assume that France and Italy are simply cutting corners; that they lack the political willpower to see these structural reforms through. But that would ignore the fact that these fiscal problems are an inevitable result of a misguided currency regime that comprises 18 countries who share almost nothing in common besides their location.

The reality is that the euro has been a woeful failure. It’s been in crisis for almost half of its existence and it could be more than five years before the region finds itself on solid economic footing. The ECB’s stress tests might increase confidence within the financial sector temporarily but as long as the euro exists a crisis will never be too far away.