European banks Stress relief

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Article by: The Economist

Europe’s banks are in decent shape—but that is not enough to repair its economy

FIVE years ago this month, the discovery of a black hole in Greece’s public finances marked the start of the euro-zone crisis. Policymakers have scrambled to contain it ever since. The outcome of their latest ploy, a probe of the continent’s banks intended to demonstrate their solidity, was revealed on October 26th. Results were mostly encouraging, at least outside Italy. But more will be needed to prod Europe’s economy back to growth.

Run over several months and involving 6,000 staff, the “stress tests” were certainly more diligent than Europe’s past attempts, which on several occasions resulted in banks faltering soon after they were pronounced healthy. Much of the work was overseen by the European Central Bank (ECB), which is taking over regulation of the euro zone’s biggest lenders next week.

Probing the books of the 130-odd banks involved unearthed minor flaws rather than the graveyards of skeletons some had feared. The ECB found €136 billion in troubled loans banks had not already owned up to, bringing the European total to €879 billion ($1.1 trillion). But the correction is piddly compared to the €22 trillion of assets they hold.

Regulators used the revised numbers in a simulation of how banks would fare in a severe recession. They concluded 25 of them would experience losses big enough to reduce their capital below the regulatory minimum, with a collective shortfall of €25 billion. But given the tests were run on end-2013 figures and most weak banks have been busily raising capital since, only €9.5 billion more is now needed, at just 13 banks—a small fraction of the €200 billion raised since mid-2013. Only seven have more than €500m to raise (see chart).

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Sceptics question how tough the tests really were. Even the worst-case economic scenario failed to gauge the impact of deflation, for example, which would cause defaults to soar, since it would reduce firms’ and households’ income relative to their debts. Nor did it assess most state-owned banks in Germany, which will remain the purview of the national regulator and many of which are believed to be full of dud assets. But in most respects they were as rigorous as stress tests carried out in America in 2009, which proved a turning point for the financial sector there.

The tests did highlight weakness in Italy’s banks, home to four of the institutions still in need of fresh funds. Monte dei Paschi di Siena, the country’s third-largest bank, was by far the most prominent lender to flunk; its shares slumped this week and it is now considering “strategic options”. Most other failures were in the small, struggling economies of the euro zone’s periphery.

One immediate outcome of the tests was encouraging: the interest rates banks pay to borrow decreased slightly, as fears over their solvency abated. As banks rely on short-term borrowing to fund around half the loans they extend, that is equivalent to a factory getting a big price cut from a supplier. The rebate should be passed on to borrowers in the form of lower rates. This change will be felt most strongly in the periphery, where firms have been paying higher interest rates on loans than their rivals in the euro zone’s core.

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Banks still hold a disproportionate amount of their own country’s sovereign debt, however, so any sign of a fiscal crisis could easily undo them. The creation of a “banking union” underpinned by a single supervisor within the ECB is part of a broader plan to cut the “doom loop” that has tethered Europe’s banks to the fortunes of their government (and vice versa)—one of the biggest flaws in the design of the single currency.

For now, the main problem for Europe’s banks is the continent’s anaemic economy. They have been proved (mostly) solvent, but whether they are viable depends on whether they can find customers both willing to borrow and able to repay. Few firms are bullish enough to expand, even if banks are ready to back them.

Before the stress tests, banks were seen as an obstacle to growth, giving ammunition to policymakers reluctant to boost demand, for example through a bond-buying scheme at the ECB or by slowing budget cuts. Those arguments have now been weakened. A healthy financial sector is a necessary but not sufficient condition for a revival of the euro zone.

From the print edition: Finance and economics

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