What Europe Can Learn From the U.S. Bank Crisis; Stress tests will not be credible until the European Stability Mechanism can directly recapitalize banks

What Europe Can Learn From the U.S. Bank Crisis

Stress tests will not be credible until the European Stability Mechanism can directly recapitalize banks.

BENN STEIL And DINAH WALKER

Against a backdrop of stagnant euro-zone economic output and declining inflation, expected to fall below 0.6% for this month, European Central Bank officials signaled on March 25 that they were willing to take far more aggressive action to drive down borrowing rates for private business. That includes negative rates on deposits at the ECB—meaning banks would be charged for keeping reserves there—which would, in theory, encourage banks to lend funds currently parked at the central bank.

In practice, however, the European Union will have to make more radical banking interventions before ECB borrowing and lending rates lead to more plentiful and less costly private credit. In this, the ECB should heed the lessons of the U.S. bank stress tests.

Banks in the euro zone account for a far higher proportion of commercial credit than in the more securities-market focused U.S.—80% compared to 20%. Yet euro-zone banks have shown little inclination to pass on lower borrowing costs to private business, owing to a legacy of (unacknowledged) bad debts built up during the first decade of the euro’s existence.

Euro-zone policy makers have been struggling to strengthen the balance sheets of both banks and governments, but each is dragging down the other. Banks facing large loan losses have been increasing their already outsize exposure to euro-zone sovereign debt, an investment that falls in value as fears rise that the governments will be called on to bail the banks out.

European banks have been trying to repair their balance sheets by raising capital, but uncertainty over the quality of their assets makes such capital expensive. They have therefore resorted to cutting back on their lending, which further weakens the euro-zone economy.

The ECB hopes to restore market confidence in euro-zone banks by conducting stress tests on 128 of the largest, representing 85% of euro-zone banking assets. Euro-zone authorities have conducted stress tests before, but with little to show for it.

In 2011, the European Banking Authority conducted what was promoted as a stringent test of euro-zone bank health. Dexia, DEXB.BT 0.00% the large Franco-Belgian lender, passed with flying colors, only to require a government bailout a few months later.

In 2012, Spain conducted a much-heralded test with similarly conspicuous flaws. It ignored banks’ large exposure to risky foreign assets (such as Portuguese debt) and assumed an “adverse scenario” in which unemployment was no worse than it was when the test was conducted. The ECB aims to do better, but its planned test suffers from another flaw that plagued the previous tests: There is no credible mechanism to ensure that banks judged to need more capital are able to secure it.

The Council of the European Union has laid out three steps a bank must take to raise capital if the ECB’s assessment reveals a shortfall. First, tap private markets. Second, if more capital is needed, apply for public funds from its home-country government. Third, if a shortfall remains after the national backstop has been exhausted, seek funds from the supranational European Stability Mechanism (ESM).

The problem is that national governments and the ESM are not an effective backstop for institutions unable to raise sufficient capital in private markets. Securing capital from already highly indebted national governments increases their indebtedness and makes the debt that they have issued, and that their banks hold, less valuable, thereby increasing the banks’ capital shortfall.

The ESM, the capital provider of last resort, is only permitted to recapitalize banks indirectly, through loans to national governments. This provision does nothing to rectify the problem that if a government is already highly indebted it is not in a position to recapitalize banks with yet more borrowed funds. As a result, there’s no reason the markets should be comforted by the new testing regime.

Fortunately, there is a solution. The European Stability Mechanism’s board of governors has agreed on the main provisions of a reform by which the ESM would allow direct bank recapitalization once the European Central Bank has assumed supervisory responsibility for euro-zone banks, which should happen in November.

While German law expressly forbids the ESM from assuming direct bank financial risk, Germany’s coalition parties agreed in November to support the ESM making available up to €60 billion for bank recapitalization. German finance minister Wolfgang Schäuble has indicated that once the Bundestag amends the law he will be in a position to vote for the necessary reforms within the ESM board.

The European Central Bank stress-test results should be published only after the ESM has been legally empowered to recapitalize euro-zone banks directly. U.S. experience supports this proposal. The federal banking supervisors’ stress tests of 2009 were a turning point in the financial crisis owing to the market perception that they were tough and credible. The supervisors could, critically, afford to be tough, as funds from the Troubled Asset Relief Program were by that time available through the Capital Assistance Program to recapitalize banks deemed to have a shortfall.

In the end, the Capital Assistance Program did not need to provide any capital to banks following the stress tests. The knowledge that the CAP backstop was available was sufficient to encourage private investors to step forward. German lawmakers should take comfort from this precedent.

Mr. Steil is director of international economics at the Council on Foreign Relations and the author of “The Battle of Bretton Woods” (Princeton University Press, 2013). Ms. Walker is an analyst at CFR.