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Euro zone mustn’t flunk bank cleanup

One reason the euro zone is in such a mess is that it hasn’t had the courage to clean up its banks. The United States gave its lenders a proper scrubbing, followed by recapitalisation, in 2009. By contrast, the euro zone engaged in a series of half-hearted stress tests that missed many of the biggest banking problems such as those in Ireland, Spain and Cyprus.

In recent years, the zone has started to address these problems on a piecemeal basis. But it is still haunted by zombie banks, which are not strong enough to support an economic recovery.

The European Central Bank now has a golden opportunity to press the reset button in advance of taking on the job of supervisor in mid-2014. It mustn’t flunk the cleanup.

Mario Draghi, the ECB president, is alive to the opportunity and the threat. His fear is that, even if the supervisor does its job properly, there won’t be a safety net for troubled banks that can’t recapitalise themselves. This is why he called on governments last week to make an explicit commitment to provide such a “backstop”.

Draghi highlighted the contrast between the U.S. stress test, in which Washington committed to plug any balance-sheet holes, and the last European stress test conducted by the European Banking Authority in 2011 which lacked such a commitment by governments. The U.S. test launched its economy on the road to recovery; the EBA one triggered a new phase in the crisis.

The moral is obvious: without a safety net, making a clean breast of problems can provoke panic. The supervisor may as a result be tempted to continue sweeping problems under the carpet. The euro zone’s recovery would then be further delayed and the ECB’s credibility destroyed.

So far, governments have not responded to Draghi’s request for a backstop. In the meantime, the ECB and the EBA – which are working on different aspects of the cleanup – have many issues to clarify themselves.

First, who exactly will review the banks’ assets? The ECB does not yet have the manpower to do it. So it has to rely on national supervisors. The snag is that these national supervisors could have an incentive to hide problems in their banks so the cost of bailing them out is ultimately borne by the euro zone as a whole.

Draghi’s answer is to get supervisors to cross-check the balance sheets of banks in other countries – and to reinforce the audit’s independence by involving private-sector assessors. The latter suggestion originally provoked unhappiness in France. But at a recent dinner with central bank governors, Draghi pushed his solution through.

That still leaves the question of whether the ECB can conduct a sufficiently in-depth review given that it wants to finish the whole process by next spring. It needs to figure out how likely loans are to turn sour and whether banks have taken adequate provisions against that possibility. Around 140 of the euro zone’s top banks will be reviewed.

The ECB should also look into whether lenders have used appropriate “risk weights” for their assets. A risk weight determines the size of capital buffer a bank is required to hold. There is a widespread suspicion that many lenders are using artificially low weights to give the misleading impression that they are well capitalised.

After the ECB completes its review, the EBA will conduct a stress test to check whether banks can survive a shock. This raises many other questions including: how big a shock it will test; how much capital banks will need to have in this stressed scenario; and how long they will get to restock their capital if they fail the test. If the EBA is too soft, the test will be exposed to ridicule in financial markets.

Yet another issue is whether capital shortfalls will be expressed as an absolute number – such as 1 billion euros – or as a percentage of risk-weighted assets. The last EBA test plumped for the percentage method, with the disastrous consequence that many banks solved their capital problem by selling assets and stopping lending – so further crushing the economy. Ewald Nowotny, an ECB council member, suggested to Reuters last month that this error would not be repeated.

Once all this is dealt with, the question then becomes who will provide a backstop if the bank has a capital shortfall that it can’t fill itself and its government has too much debt to help out.

One option would be for the European Stability Mechanism (ESM), the zone’s bailout fund, to inject capital directly into banks. But Germany seems to have rejected this.

The main alternative is that the ESM should lend money to national governments, which could then pop it into their banks. That’s what happened last year when Spain’s lenders got into trouble.

The snag is that this would add to the government’s deficit and debt. A partial workaround could be for the European Commission to ignore any capital injections when it determines whether governments are doing enough to cut their deficits. Without such forbearance, they could be forced into another round of growth-pummelling austerity measures.

With so many issues to resolve, there is a risk that Europe’s mega bank cleanup will either be another damp squib or even create more damage. Having wasted five years failing to address the problem properly, the euro zone must make sure this does not happen.

Summary:
The zone is haunted by zombie banks - the result of sweeping bad loans under the carpet. The ECB has a golden opportunity to press the reset button in its new role as supervisor. But if the exercise is handled badly, the economy and its own reputation will suffer.