Post-crisis journey of rebuilding confidence in Europe's banks

How successful were the stress tests and the asset quality review (AQR) carried out on Europe's biggest banks - and announced to great fanfare - just over a week ago? The answer depends on how you define success. One simplistic way to measure it is whether the results went down well in the market.

By this yardstick, the tests flopped. There was a brief rally in share prices, as predicted by analysts, while investors digested the results from the European Central Bank and European Banking Authority. But it quickly faded and banking shares fell as people realised the exercise would not provide a panacea for the problems at Europe's banks.

Another way to judge success is to examine the severity of the process. The obvious comparison is with the periodic stress tests carried out by the US Federal Reserve since 2009. They are credited with helping to restore US banks to health after the financial crisis.

Helpfully, the ECB provides some data that can be compared with figures from the US tests. Europe applied imaginary "stresses" that reduced the aggregate capital in the region's banks by €262.7bn and cut the common equity tier one ratio for the median bank from 12.4 to 8.3 per cent.

This reduction of 4 percentage points in European banks' capital ratios compares with a 2.9 per cent cut to the median projected capital ratio of US banks, under the Comprehensive Capital Analysis and Review (CCAR) carried out by the Fed this year.

On this measure, the European exercise starts to look more credible. Equally tough-sounding is the outcome: 25 of the 130 participating banks failed the ECB stress tests and AQR. Some of these are quite sizeable: Banca Monte dei Paschi di Siena and Banco Popolare are Italy's third- and fourth-biggest lenders, while Piraeus is the biggest in Greece, and Millennium BCP is the largest in Portugal.

However, critics continue to take pot shots at the credibility of the examination. Economists argue that it failed to consider deflation - one of the biggest threats to the eurozone economy. The tests assumed 1 per cent inflation this year, in line with economists' forecasts in April when the rules were finalised. But that is well below the latest eurozone inflation figure of 0.3 per cent - a five-year low.

The process has also done little to break the "doom loop" between the banks and their governments, critics claim. The test of the banks' combined €2.7tn of sovereign debt exposure only resulted in a €17bn reduction of capital and €19bn of impairments.

Other bugbears include the fact that the tests did not include the vast litigation costs still facing the banks. Nor did they model the fallout from a deepening Ukraine crisis for banks with exposure to Russia. Sceptics argue that the total capital shortfall of €24.6bn is puny when compared with the €22tn of assets held by the 130 lenders included in the process. Surely, Europe's banks need to raise more than that to restore credibility, they say.

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Instead, the ECB says the banks actually need to raise less. This is because it has allowed the failures to count capital raised since the tests' December 2013 cut-off point towards covering any shortfall. Greek banks can rely on their restructuring plans, even though they were submitted too late to count in the official results. Austria's Volksbanken is already being wound down and other national regulators, such as Belgium and Portugal, say their banks have done enough to cover their shortfalls.

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That leaves the world's oldest bank - Monte dei Paschi - with a €2.1bn hole and its smaller Italian rival Banca Carige needing €800m. And that is about it.

But hold on, say ECB supporters. To truly measure the impact of the stress test, they argue, the figures should include the €56bn of capital raised pre-emptively by Europe's banks since the start of the year.

Other measures of success would be the extent to which the AQR prompts a rebound in bank lending to eurozone companies and causes consolidation among weaker lenders. But beyond a possible bid for Monte dei Paschi, neither looks very likely. Morgan Stanley expects weak demand from banks for the ECB's second offer of cheap four-year loans, estimating total take up in the first two rounds of its Targeted Longer-Term Refinancing Operations, or TLTROs, at €193bn-€243bn, out of a possible €400bn. This hardly suggests banks will unleash a flood of loans.

But take a step back. Examining 12,000 data points at each of the 130 banks will stand the unified eurozone banking supervisor in good stead as it prepares to take charge on Tuesday. The process itself may not have been ideal. But the rebuilding of confidence in Europe's banks after the crisis is a journey, not a destination. The ECB is likely to repeat the exercise every year and it will learn from its early mistakes.

martin.arnold@ft.com

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