Stress is good for Europe's battered banks

Previous stress tests of the eurozone's banking system were far from rigorous, but a spate of capital raisings suggests the banks are getting serious about getting on a sounder financial footing.

If at first you don’t succeed…

This time it appears European regulators are finally achieving some success in their attempts to re-base the foundations of the eurozone’s banking system.

Yesterday Germany’s biggest bank and the European bank with the largest investment banking operations, Deutsche Bank, announced plans to raise about $11.7 billion of new capital, including a $2.5 billion placement to Qatar’s royal family.

That announcement coincides (and it is no coincidence) with the start of the latest and most credible series of stress tests of the eurozone’s banks.

With the European Central Bank assuming responsibility for regulating the region’s banks from November, the initial asset quality review and subsequent stress testing of bank balance sheets is seen as the most serious attempt since the financial crisis to put the banks on sounder footings and to break the dangerous nexus between the big European banks and their leveraged governments.

Whether it does so remains to be seen, but Deutsche Bank’s capital raising fits within a Europe-wide scramble by banks to raise capital since the tests were foreshadowed in the middle of last year.

European banks have raised more than $50bn of new capital since July last year, most of it through capital raisings but with contributions from divestments and the unwinding of carry trades based on their access to cheap funding from the ECB. In 2011 the ECB injected more than $1.7 trillion of three-year low-cost funding into the Eurozone’s banking system to promote lending, but those funds were used primarily to buy sovereign bonds in order to lower the banks’ government’s costs of funds and perceived riskiness.

The spate of capital raisings hasn’t completely dispelled cynicism about the rigour of the tests. There is considerable latitude still being given to the banks’ treatment of sovereign bonds on their balance sheets, but it would seem that banks are taking this set of tests more seriously than their predecessors.

In 2010 the European Banking Authority conducted its first set of stress tests. As an indication of the tests' rigour, they gave a tick to Ireland’s bigger banks. Ireland’s banking system nearly collapsed almost immediately afterwards.

In 2011 the ECB had another go. Among the more highly-rated banks in the tests was the Franco-Belgian Dexia, which had been one of the earliest banks to be bailed out by taxpayers in the immediate aftermath of the financial crisis. Almost immediately, Dexia had to be bailed out again, at a cost of about $17.5bn, and Spain’s Bankia had to be partly nationalised after disclosing massive losses.

Not surprisingly, those earlier tests were seen as cosmetic exercises. They were designed to generate confidence in the eurozone’s banks without actually forcing them to do anything significant that might negatively impact economic growth or exacerbate the parlous state of the region’s finances and cost of debt at the time.

By contrast, the series of tests the US has conducted on its banks since 2009 have been regarded as tough and rigorous and have forced major changes to banks’ balance sheets.

Thanks to Mario Draghi’s pledge to do ‘’whatever it takes’’ in 2012, the Eurozone’s stability has improved markedly. It has given the banks the time and the opportunity to improve their balance sheets and reduce the extent of the potentially destructive feedback loop between the region’s banking system and sovereign funding.

The tests, along with the handover of regulatory responsibility for the banks from the European Banking Authority to the ECB in November, are a key part of a wider process of moving towards a banking union that will include processes and structures for dealing with failing banks at arms’ length from their governments.

If that can be achieved, it would then enable the authorities to focus on strategies for reducing the latent threats to stability and growth posed by the high levels of sovereign debt within the weaker economies in the region.

The general reduction in the cost of sovereign debt created by the floods of cheap money flowing around the globe has eased Europe away from the crisis environment that it was experiencing until Draghi’s line-in-the-sand moment.