Prejudice, Politics Block Stress Tests on EU Banks

Is it time for Europe to copy America and conduct public, detailed bank "stress tests"? That question is haunting the transatlantic policy debate — and global markets.


In recent weeks a palpable — and growing — sense of fear has erupted around Europe's banking system. Share prices have fallen. Three-month dollar Libor rate has doubled to about 55 basis points. Euro zone banks' ability to roll over commercial paper has dwindled (last week alone their outstanding commercial paper fell $15 billion). Indeed, such is the mood of unease that overnight deposits at the European Central Bank rose above €360 billion ($432 billion) this week — a record.

Moreover, if you ask investors — or bankers — to explain this trend the answer that usually crops up revolves around a lack off trust. Most notably, there is a perception that euro zone banks' balance sheets are dangerously opaque, stuffed with rotten (or potentially rotten) assets, such as risky sovereign bonds or legacy mortgage bonds. There is also a fear that euro zone banks have too few reserves, partly because they have raised far less capital than their U.S. rivals in the past two years.

Hence that debate about "stress tests". After all — and as U.S. officials such as Timothy Geithner have been forcefully pointing out to their European counterparts in recent weeks — back in the spring of 2009 similar fears beset American banks. But Washington conducted public stress tests, published the results and then forced banks to raise capital, helping to turn round sentiment.

Something similar occurred in Japan, too, almost a decade ago, when the Japanese government eventually performed stress tests of its troubled banks. So, the Americans keep asking, why doesn't Europe do the same? "It is pretty obvious what the problem is — but the Europeans just don't seem to get it," one frustrated American official fumed recently.

Could this be about to change? Some observers hope so. Last weekend Mario Draghi, governor of the Bank of Italy, issued public support for the idea, noting that "the decision of the U.S. government to undertake these [stress] tests last year and publish them had a very beneficial impact both on the market and on the banks themselves". Jean-Claude Trichet, head of the European Central Bank, has revealed that the ECB is overseeing stress tests, adding "I expect appropriate communication will take place [about that]." Yesterday he stepped up pressure on national authorities to publish stress tests.

But the €360 billion (plus) question right now is what Trichet — and other euro zone leaders — consider to be "appropriate communication". When the U.S. did stress tests, these produced details about specific banks. However, this is not what euro zone leaders appear to have in mind. This week, for example, the Austrian government warned that it would only back stress tests if these were limited to sector-wide analysis. The German and French governments have privately voiced similar views. Indeed, the only euro zone country which appears to back U.S.-style stress tests — and has even (laudably) done its own — is Ireland.

Why? One problem is simple prejudice: the Germans and French loathe the idea of being lectured by Americans (particularly since they blame America for having started the whole banking crisis). A second, more practical, problem is that some euro zone officials fear they would spark market turmoil if stress tests revealed that individual banks were short of capital — but they did not have a clear solution to plug that gap. After all, the European public is reluctant to use any more taxpayer money to support banks. Moreover, capital markets are so jittery that it could be hard to plug any gap just with private funds.

However, the really big problem is politics. In Germany, the government has just persuaded its population to support a very unpopular, costly plan to "save" Greece (and other euro zone countries) from default. Given that, German officials understandably do not want to tell their voters that they are also conducting bank stress tests to cope with the possibility of, say, a Greek default (let alone need to ask taxpayers for more funds). But if Germany does not include that scenario in any stress tests, these would lack credibility. Hence the fact that one senior euro zone regulator laments "it is just politically impossible for [Germany] to do stress tests".

That in effect leaves the core euro zone trapped. If it follows America and does public stress tests, there could be political and market convulsions. But if the euro zone does not do stress tests, it will end up looking like Japan in the 1990s: namely, a world wracked by corrosive investor unease, market distrust and stealthy slides in asset prices.

Maybe the ever-wily Trichet will find a way to escape that trap when the ECB finally decides to make "appropriate communication". But don't count on it. No wonder Americans are so frustrated, and investors so uneasy.