On Sunday, October 26, the European Central Bank (ECB) will release the long-awaited results of its bank stress tests. Mirroring the action taken by the United States Federal Reserve in 2009, these examinations are meant to determine once and for all the bill of health for European Banks before the ECB becomes their key regulator one week later. European banks are being examined in order to promote transparency across European bank balance sheets, and to ensure that all banks have the capital that they need to sustain future crises.
News headlines have recently caught up with Europe’s economic reality: spurts of growth believed durable by consensus forecasters have proven mere inventory rebuilding, and growth is unlikely to pick up to support employment in the next few years. But the upcoming stress tests hit right to the heart of Europe’s woes. While macroeconomic fundamentals in southern Europe remain comparatively weak, even northern European creditor nations host poorly capitalized banks and could be gravely impacted by a financial market panic.
The ECB has thus faced an enormous, and hugely important challenge. If the results show Eurozone banks are relatively healthy, the immediate pressure that banks have endured to raise additional capital could wane, improving the supply of loans to the economy. However, Europe’s businesses, 85% of which are funded by bank lending, will continue to doubt the safety of additional investment, suspecting the banks may not be healthy and are unlikely to get better, thus reducing investment confidence. On the other hand, extremely harsh results, which many banks in Europe no doubt deserve, could induce a financial market panic that jettisons the continent from very low growth to outright crisis.
Which banks are most at risk?
The ECB’s comprehensive look at Europe’s banks has meant sifting through about 135,000 loan files at 130 of the largest banks in the eurozone, or approximately 85% of banks’ outstanding loans and other assets. The banks will also undergo stress tests to see if they could withstand major recession, bond market panic, and other adverse situations.
The ECB has kept some of its methodology secret, in order to prevent banks from trying to manipulate the results. However, those announcements that have been made have resulted in bad news for banks so far. In May, Moody’s downgraded 82 European banks in response to a new EU law that makes banks mutually responsible for risks in the event of another crisis, highlighting the breadth at which Europe’s banking crisis has sustained its reach. The majority of these banks were not southern European “debtor” nations, but rather from northern European “creditor” nations. The downgrades were also spread throughout EU and non-EU countries, as well as Western, Central, and Eastern Europe.
What should businesses expect from the results?
Businesses should take seriously two threats. First, weak banks could come from countries perceived by news headlines and by top-line growth targets as “safe”, creating financial market instability throughout the region. Second, regardless of the location of struggling banks, the requirement that major European banks create more capital will exacerbate both the supply- and demand- side contractions in credit that will mute growth in Europe next year. Lenders deemed unhealthy will need to hold even more capital, reducing the supply of loans, and borrowers will be deterred by the obscure operating environment, limiting demand.
As a result, the key leading indicator for European economic stability – bank lending – is unlikely to improve next year. Sunday’s bank stress test results will provide a helpful barometer for just how far we might expect growth forecasts for next year to fall.
For more information on what to expect in Sunday’s bank stress test results, see FSG’s report on Eurozone Financial Weakness.