Will Europe’s banking ‘big bang’ loosen lending?

In the biggest advance in European integration since the launch of the euro in 1999, the European Central Bank will take charge of supervising banks from Helsinki to Lisbon in November after subjecting their books to unprecedented scrutiny.

The aim is to restore confidence in the euro zone’s banks, battered by the 2007-8 global financial crisis and the currency area’s own debt crisis, and help revive lending to businesses and households, especially in stricken southern Europe.

Many economists say Europe is at least five years behind the United States in cleaning up its banks, which explains in part why the euro zone’s economic recovery is so slow and fragile.

But it is not clear that the ECB exercise, involving a rigorous review of 131 banks’ assets and liabilities and a tough test of their ability to withstand economic shocks, will be sufficient to get more credit flowing into the «real economy».

The problem lies less in any design fault in the process, which analysts agree is more demanding and transparent than two previous rounds of softball stress tests in 2010 and 2011 conducted under the aegis of the European Banking Authority.

The issue is more whether credit to firms in Italy, Spain, Portugal and Greece is scarce and expensive because shaky banks there cannot borrow and are reluctant to lend, or because of a shortage of demand in stagnant economies.

Where there is credit demand, banks scarred by the damage that bad lending can do may be too scared to lend to all but the safest of companies.

There is also concern about whether politics will get in the way of the ECB’s drive to restructure or wind down «zombie» banks and reverse financial fragmentation in Europe.

Daniele Nouy, the French official heading the ECB’s Single Supervisory Mechanism, has vowed to resist political pressure, to which she says national supervisors have been prone in the past. Those same national supervisors will now sit on her board.

“We will not shy away from winding down banks,» she told German magazine Der Spiegel in June.

The euro zone crisis sparked an outbreak of banking nationalism, with governments and regulators trying to curb cross-border exposure. In one notorious case, Germany’s banking supervisor barred a German unit of Italy’s Unicredit (CRDI.MI) from transferring funds to its parent company.

Nicolas Veron, an expert on banking supervision at the Bruegel economic think-tank in Brussels who was among the first to propose a European banking union, says the crunch will come if governments resist ECB efforts to close down ailing lenders.

“Lots of governments are worried that their banks may have to be closed,» he told Reuters. «It is unclear how far the ECB will go in clashing with governments. That won’t be entirely settled before the ECB takes over supervision on Nov. 4.”

There could be disputes over the ECB banking supervisor’s treatment of government or local authority guarantees, of certain forms of hybrid capital and of the valuations of assets such as derivatives and foreclosed real estate portfolios.

Political pressure has already led to one exception being made for troubled Franco-Belgian lender Dexia, which has had 12 billion euros ($16.11 billion) in state aid and is being wound down. According to sources familiar with the matter, Dexia will not have to prove it could withstand a financial crisis, reducing the chances of it needing further public funds.

Greece, the country hardest hit in the euro zone crisis, is asking that stress tests on its banks take into account new restructuring plans and are not just based on last year’s balance sheet.

Ironically, some of those issues may come to a head in Germany, Europe’s biggest and most robust economy. Despite restructuring, some of the six Landesbanken regional banks are propped up with state guarantees and are carrying risky assets in shipping loans and commercial real estate.

They are politically highly sensitive because they are owned by regional authorities and local savings banks and play a role in sustaining fragile sectors such as shipping.

The stress test results will be published in the second half of October and the ECB proposes giving banks just 48 hours to review the findings, although bankers want more time.

They will then have two weeks to come up with a plan to plug any capital shortfall, and up to nine months to raise the money.

Veron expects the «zombies» – banks deemed not to have sufficient capital to withstand economic shocks – to fall into two groups. The weakest may not even take the stress test in October. Another group will take the test but fail.

“Group 1 will face the firing squad. Group 2 will be on death row but not yet executed,» he told Reuters. «They have to kill the zombie banks, and heal the ones that are only wounded. Delivering on this will be crucial.”

One objective declared by European Union leaders in 2012 «to break the vicious circle between banks and sovereigns» has fallen somewhat by the wayside.

Banks are not being pushed to reduce their holdings of home-country government bonds, which will continue to be treated as risk-free assets if they are held to maturity, a decision that has drawn criticism from some economists.

Veron said the issue was no longer decisive for market confidence since investors had concluded euro zone governments will not allow another member state to default, as Greece did when it forced bondholders to take writedowns.

While some banks are bound to fail the test to ensure the exercise is credible, many have acted in advance to raise capital, sell assets and reduce leverage to ensure they pass it. That may indeed have slowed lending to business over the last year.

Germany’s giant Deutsche Bank (DBKGn.DE) raised 8.5 billion euros in June mostly through a rights issue and the ECB says overall euro zone banks have increased their capital by 198 billion euros since July 2013.

There is bound to be rot exposed in the woodwork of other lenders, as last month’s run on two banks in Bulgaria and the woes of Portugal’s Banco Espirito Santo (BES.LS) illustrated.

Media speculation over how many banks may fail could make the next three months bumpy on the markets.

But on balance the ECB’s stress tests seem likely to achieve the main goal of restoring confidence in euro zone banks, even if that in itself is not enough to start lending more again.