Stress test blues: the trials and tribulations of European banks.

• Author: Engelen, Klaus C.

One thing has been clear since the European Central Bank was empowered as top supervisor for eurozone banks at the June 2012 EU summit. Before the ECB would assume responsibility as the euro area's lead bank supervisor in November of this year, a comprehensive health check of bank balance sheets and a tough stress test in cooperation with the London-based European Banking Authority would be needed.

So it was timely for The Economist at the beginning of this year to look at the euro area's negative legacy regarding bank stress tests. In an article titled "Setting the exam," it reminded its readers, "Stress tests have had an inglorious history in Europe since they were introduced in the wake of the financial crisis along with new institutions such as the much-scolded EBA, which has the job of harmonizing bank regulations and coordinating national supervisors across the 28-country EU."

A July 2011 Bloomberg news report on the market reaction to the 2011 EBA stress test results, "EU bank stress tests missing sovereign defaults fail to convince analysts," captures the European Banking Authority's spectacular failure. "The European banking stress test is unlikely to provide much in terms of assurance to the markets ... Concerns about contagion of the sovereign debt crisis into core Europe have taken center stage." Dexia, for example, the Franco-Belgian bank that had required state aid in 2008, passed the EBA's stress tests in the summer of 2011, but three months later had to be rescued in another bail-out operation by the French and Belgian governments.

To put the 2014 EBA/ECB stress test in perspective, leading experts such as Harald Benink, Harry Huizinga, Daniel C. Hardy, and Heiko Hesse argue that unlike the United States, Europe failed to recapitalize its biggest banks following the financial crisis of 2007-2009. Instead, policymakers have gambled that economic recovery would raise the profitability of financial institutions, enabling them to increase their capital buffers over time. It's now clear that this strategy failed. Without such recapitalization, there is the danger that economic stagnation will continue over a long period, putting Europe on a course toward Japanese-style inertia and the proliferation of zombie banks.

Ever since Dutch Finance Minister and Eurogroup President Jeroen Dijsselbloem, backed by German Finance Minister Wolfgang Schauble, shifted eurozone bank rescue policy in the direction of resolution without using taxpayer money in the case of Cyprus, the need for credible bail-in rules and a new push for cleaning up bank balance sheets has become obvious. The chaotic Cyprus rescue marked a low point in the governance of the ECB and the European System of Central Banks, since the Eurosystem kept Laiki, the country's second-largest financial institution, above water with Emergency Liquidity Assistance loans to the tune of 9.4 billion [euro], although Laiki was bankrupt for more than a year.

But the ECB as lead bank supervisor, along with major euro area governments, is pushing in the direction of precautionary bank recapitalization, showing that the eurozone's pro-bailout interests are still very powerful. Whether the EU Commission as guardian of strict state aid rules can make a difference remains to be seen.

ENTER THE NEW EUROPEAN BANK SUPERVISOR

To put it mildly, the ECB's launch as the eurozone's lead bank supervisor was bumpy. In the driver's seat is Daniele Nouy, a former veteran French bank supervisor, who chairs the Supervisory Board of the single supervisory mechanism at the ECB. She and her new team need to cooperate closely with the London European Banking Authority regulators in the framework of the ECB's "comprehensive assessment" that includes an asset quality review, a stress test, and a supervisory risk assessment. According to the ECB, it is "the largest such exercise ever undertaken in terms of the numbers of banks, their overall size, and geographical reach." As the ECB announced in its October 2013 note, "Given the unprecedented scale of the exercise that will involve some 130 credit institutions in 18 Member States, covering approximately 85 percent of euro area bank assets, a system-wide approach is necessary. The ECB will conduct the exercise, detailing its design and strategy, monitoring its execution in close cooperation with the NCAs." (In official ECB terminology, all national bank supervisory authorities--whether operating under the helm of central banks or standing alone as in the case of Germany's Federal Financial Supervisory Authority--are called "national competent authorities.")

In a further step, on March 11,2014, the ECB published its manual for the asset quality review. It contains the applicable methodology and provides guidance for the NCAs and their third-party support in carrying out the exercise as part of the comprehensive assessment. In October 2014, the results of the asset quality review will be released together with the results of the stress test conducted by the ECB in cooperation with the European Banking Authority. Subject to the comprehensive assessment are the major European banks that will fall under the ECB's supervision in the future.

"The banking union," argues Nouy in an upbeat mood, as she recently addressed the traditional Economic Conference of the National Bank of Austria in Vienna, "is testimony to what Europe can achieve when it sets its mind to it, and by working together the ECB and the national competent authorities can meet their remaining challenges.... And by 'we', I mean all of us together: staff from the ECB and from the NCAs."

ONE SHOT TO ESTABLISH CREDIBILITY

After decades as a bank supervisor, Nouy seems to be aware of the reputational risk a failed health check of bank balance sheets and another stress test debacle pose in the build-up phase of European banking union. "We know that we have a single opportunity to establish our credibility," she confessed in a recent Financial Times interview. She has good reason to fear that the ECB will further damage its credibility by taking on the mammoth task of pan-European bank supervision in a rush and without prior supervisory experience.

Concerns about possible failures and setbacks in establishing bank supervision at the ECB level have also reached the top levels of the German government. Chancellor Angela Merkel is not hiding her apprehension with respect to establishing the first pillar of the ambitious European integration project.

Speaking at a Berlin conference of Germany's cooperative banks about the challenges of the ECB health checks for the large euro area banks, Merkel warned, should politicians interfere, "the reputation of the ECB as an oversight authority will be damaged before it starts." In her view, it is "very important to regain the confidence of international markets in the European banking system."

Contrasting with apprehension from Nouy and Merkel are the threats of ECB President Mario Draghi that, "Officials won't hesitate to fail banks in its stress test" since "banks do need to fail" to prove the credibility of the exercise. Draghi expressed this warning in an interview with Bloomberg last October. "If they do have to fail, they have to fail. There's no question about it."

At the Eurotower site in Frankfurt, where the pan-European bank supervision authority is in a somewhat chaotic construction stage, an expanding press contingent has been doling out doubtful progress reports. Nouy and her newly formed single supervisory mechanism team cannot hide their problem: they have to...