European Central Bank launches push to strengthen banks, get credit flowing to economy

FRANKFURT – The European Central Bank is launching a review of 128 of the eurozone’s biggest banks, a push to restore faith in the financial system — and lay the groundwork for growth — after similar studies fell short.

The review will be a key test of the ECB’s credibility as it prepares to take over as the European Union’s banking supervisor. Previous stress tests carried out in 2009 and 2011 by another agency with more limited powers, the European Banking Authority, cleared several banks that were in need of rescuing soon after.

Europe’s slow progress in cleaning up the banks contrasts with the United States. There, officials moved early to make banks strengthen their financial buffers in the wake of the 2008 collapse of investment bank Lehman Brothers.

The ECB announced Wednesday that its review of the banks will begin next month and take a year. Working with national regulators, ECB officials will take a broad look at the banks’ holdings and financial strength. In particular, they will look for hidden losses such as loans to businesses and real estate projects that are unlikely to be repaid.

ECB President Mario Draghi called it “an important step forward for Europe and for the future of the euro area economy.”

The ECB’s review will be followed by a stress test that would simulate bank losses in a sudden economic downturn or financial crisis, conducted along with the European Banking Authority.

The question is whether that stress test will be more credible than the previous ones.

Thomas Huertas, a partner in a unit of Ernst & Young, said they probably would because the ECB will have already reviewed the banks’ balance sheets before conducting the test — something the EBA was not able to do before.

At the end, banks could be pushed to repair their finances by raising more capital or selling off risky holdings.

The issue is import for Europe’s recovery because banks that are holding soured investments, such as bad loans, may be unable or unwilling to find cash to lend to businesses that need credit to expand their operations. They may also be asking for higher interest rates to lend, blunting the ECB’s ability to stimulate the economy with lower borrowing costs.

The eurozone grew only 0.2 per cent in the second quarter after contracting for six quarters and unemployment remains high at 12 per cent.

The asset review and stress test need to be done before the ECB takes over as the European Union’s banking supervisor next year. The single supervisor is part of a broader effort to strengthen the financial system and prevent a repeat of the debt problems afflicting countries such as Spain and Ireland, where bank bailouts hurt government finances.

Ignazio Angeloni, an ECB official, said the result would call for “repair where repair is necessary” and won’t necessarily include a figure for raising new capital.

The ECB’s job may be complicated by the fact that Europe does not yet have a single authority to restructure or shore up banks that review identifies as weak. European leaders are still debating how to set up such an authority. If banks cannot raise new capital from private investors, they could turn to their national authorities. Under some circumstances, the eurozone’s bailout fund could be used, but the idea has faced stiff political resistance from governments.