Europe's Banking Union Starts on an Encouraging Note

October 27, 2014 12:30 PM

Sunday, October 26 was D-Day for Europe's banks: At noon in Frankfurt, the European Central Bank (ECB) announced [pdf] the results of its "comprehensive assessment" of the euro area's 130 largest banks, including an Asset Quality Review (AQR) and stress tests. Simultaneously in London, the European Banking Authority (EBA) announced the results [pdf] of these stress tests for a larger sample of banks, including the largest banks headquartered in the European Union but outside the euro area.

This was meant as a cathartic watershed that would allow the ECB to take over its new role as the licensing authority of all the euro area's banks and direct supervisor of the largest ones, a transfer of authority from national supervisors that will occur on Tuesday next week, November 4. The comprehensive assessment is intended to draw a line under years of unsatisfactory oversight by national watchdogs and to allow the ECB to start from a high level of trust.

On the face of it, these objectives appear to have been met, even though a definitive assessment will only be possible several months from now. The ECB identified 25 banks as having been undercapitalized as of end-2013; of these, 12 have raised enough capital this year to be technically compliant with capital requirements, but the other 13 need to submit recapitalization plans to the ECB within two weeks. Four of these are in Italy: Monte dei Paschi di Siena (MPS) (which may have to lose its independence), Carige in Genoa, Banca Popolare di Milano, and Banca Popolare di Vicenza: This puts a cloud above the Bank of Italy's reputation as a supervisor, especially as several other Italian banks also appear fragile. Farther west in Lisbon, Banco Comercial Portugues (BCP) is among the other institutions asked to strengthen their balance sheet, or else. In total, the assessment identified slightly more "problem banks" than expected but did not uncover problems so massive that they may trigger systemic instability.

Perhaps more importantly, the ECB (and EBA) flooded the market with a deluge of data, the full analysis of which will take several more days. One not-so-hidden nugget of information is how the banks would have fared if a more rigorous yardstick of capital, known as fully-loaded Basel III, had been used instead of the current "phased-in" measure that Basel III will replace in the European Union in a few years. In that case, a few significant German banks would have failed the test as well. They include HSH Nordbank, a northern German Landesbank that provides wholesale services to local savings banks (Sparkassen), in spite of the guarantees it has received for up to €10 billion from the local governments that are also its main shareholders. This group also includes DZ Bank and WGZ Bank, the two wholesale institutions that serve Germany's system of local cooperative banks (Volksbanken and Raiffeisenbanken)—possibly the biggest surprise of Sunday's entire disclosure package. The fact that Germany and Italy, two of the euro area's biggest countries, are not immune to the ECB's inquisitiveness suggests that the assessment has been kept reasonably independent from political pressure. In the two other largest countries, France and Spain, most banks passed the test successfully.

Crucially, this exercise must be seen as the beginning of a sequence of policy actions by the ECB—even as, to the thousands of professionals who participated in the process, it may feel like the end point of a long hard slog. To start with, investors and the public will need to be persuaded that there are no more skeletons hiding in the banks' cupboards. This is likely to take a few months: The credibility of the EBA-led stress tests whose results were announced in mid-July 2011 was later ruined by the problems of Dexia in October 2011, then of Bankia in May 2012. Moreover, some of the AQR's consequences will only be felt in the banks' financial statements as of end-2014: For example, more of the €136 billion of additional nonperforming loan exposures identified in the AQR may be written down at that time. Overall, the definitive assessment on the robustness and credibility of the comprehensive assessment, and specifically of the AQR, will probably have to wait until the first quarter of 2015.

Furthermore, the ECB has a lot of followup work on its plate on a number of issues it has signalled it will address gradually after its assumption of direct supervisory authority on November 4. It should gradually tighten the definition of capital to make it fully compliant with the Basel III framework, including on the contentious question of insurance subsidiaries of diversified banking groups (a point on which even today's "fully-loaded" disclosures are based on a laxer standard than the international accord, and which is particularly sensitive for several large French banks). It should put an end to the widespread practices of geographical ring-fencing of capital and liquidity by national supervisors within the banking union area, an aim that may eventually require legislative changes in Germany and elsewhere. It should vigorously encourage those banks that keep a high home-country bias in their sovereign debt portfolios to reduce it, something that ECB top supervisor Danièle Nouy has already announced. It should encourage cross-border bank acquisitions, and investment in banks by international private equity funds, to decrease the sector's current fragmentation along national lines. Finally, it should gradually bring smaller banks (mostly German, Austrian, and Italian) into its supervisory fold, as Ms. Nouy's deputy Sabine Lautenschläger has indicated.

The full economic impact of the comprehensive assessment will depend on these developments still to come. If all goes according to plan, it may unlock some of Europe's repressed growth, by allowing most banks to lend more freely now that their creditworthiness has been duly checked—even though this will not resolve a number of other problems in Europe's anaemic economy that contribute to depressed credit demand. Overall, this debut of Europe's banking union comes five years too late, but better late than never. It is an encouraging start for the most transformative policy initiative that has emerged from Europe's crisis so far.