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Stressful times for Europe’s banks

Monday, 21 Oct 2013 | 3:17 AM ET
PeskyMonkey | E+ | Getty Images

The closets of Europe's banks will be examined next year, with increasing concerns about what skeletons might emerge.

Mario Draghi, President of the European Central Bank (ECB), is expected to outline the criteria for the bank's Asset Quality Review (AQR), its stress-test of banks' balance sheets, on Wednesday. This will be the first time that the ECB announces just how stringent its review will be.

There seems to be universal agreement that these tests are: a) very important and b) potentially damaging to a lot of banks. They will be one of the most important steps in the movement towards Europe-wide banking union.

Europe's banks were at the core of the region's three-year financial crisis, trapping their governments in a "debt spiral" of dependency. After falling victim to the global financial crisis, a large number of Europe's banks needed propping up by their governments. To be able to afford this, the governments issued debt – making their finances shakier as a result.

(Read more: Why Europe should have let more banks fail)

In a response to this, Europe's leaders proposed a banking union which includes a central system to look after the winding-down of bust banks, a deposit insurance scheme and a single banking supervisor, a role the ECB has taken on.

Previous European banking stress have been criticized for erring on the side of optimism, particularly for growth forecasts and exposure to sovereign debt.

This time around, the ECB and the European Banking Authority, will want to do their best to root out any shortfalls in capital, to try and ensure there are no nasty surprises when they take over central control.

"Ineffective and incompetent execution - an unfortunate feature of many political responses during the crisis - could bring about a resumption of financial turbulence and relapse back into recession," analysts at Credit Suisse warned.

(Read more: Euro's permanent political crisis)

There are particular concerns that the bailed-out peripheral euro zone countries of Ireland, Spain, Portugal, and Greece, which have all been lent money by the International Monetary Fund and their fellow euro zone countries, will have more bad news lurking.

The continuing problems in these economies, and their banking systems, have been well-documented, and can be summed up simplistically as too much debt for too little capital.

And if it emerges that their banks are in more trouble than previously thought, this could lead to further problems for these still-vulnerable economies.

(Read more: Banks' new capital rules)

"If next year's stress tests find large holes in bank balance sheets, there is still no clear mechanism to fill them," James Howat, European economist at Capital Economics, warned.

However, because these countries have already been bailed-out, they already have extra provisions from the IMF and the euro zone. The ECB has also helped out with emergency loans to the countries' banks.

"More capital may be needed, but not on the scale of past bailouts," Credit Suisse analysts believe.

And the tests could, ultimately, be like ripping off a plaster – painful in the short term, but ultimately necessary and positive. The tests could "'speed-up' the healing process" for European banks, according to Citi analysts.

"Forcing banks to recognize the full extent of their non-performing loans and thus properly recapitalize is crucial to avoid 'zombification'," as analysts at Deutsche Bank point out.

(Read more: The 'immeasurable' risks European banks may be hiding)

Zombification, where companies continue to pay off the interest on their loans but don't repay capital or grow their business, can lead to a moribund economy. If banks start calling in more bad loans, it would help their balance sheets and free up more funds to invest -- even though this may mean more companies could fail.

"There's the possibility it proves a cathartic turning point for the euro area economy," the Credit Suisse analysts said. "Unfortunately, there's also the risk it proves to be yet another poorly executed pan-euro area policy in which confidence is further eroded."

- By CNBC's Catherine Boyle. Twitter: @cboylecnbc.

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