With its plan to take another close look at the health of banks, the European Union could make a big leap ahead in its response to the government debt crisis. But for the tests to be meaningful this time around, governments and regulators will have to swallow their pride and expose some of the region's hidden skeletons.
EU officials hope a second round of stress tests, planned for February, will do what the earlier ones couldn't: restore confidence in the region's banks by checking whether they have the financial cushion to withstand unexpected shocks.
"The problem of the European responses since the start of the year has been that they have always been slightly behind the curve," said Philip Whyte, a senior research fellow at the Centre for European Reform.
Credible stress tests now, followed by a swift recapitalization of banks shown to be vulnerable, could go a long way in taking costly uncertainty out of the markets.
European regulators first tested their banks in Sept. 2009, but the results were never published. Another round of tests, carried out this July, was made public but widely criticized for not being stringent enough.
The EU has now decided to give it another go, after months of turmoil in the government debt markets made it clear that investors are anxious to lift the lid on the interconnections between government debts and banks' health.
The bailout of Ireland and Greece, and worries about Portugal and Spain, have shown that the crisis that has rocked the European continent over the past year isn't only about overspending governments.
It is also about investors fearing what might be at the bottom of a downward spiral fed by highly indebted government, poorly capitalized banks and the cost of bailing them out.
Both Spain and Ireland until recently were model citizens when it came to sticking to the EU's debt and deficit rules, and even this year, Madrid's debts are estimated to stand at 64.4 percent of economic output, below those of Germany, the Netherlands and Austria — the region's fiscal conservatives.
But Ireland was forced to inject almost 50 billion euros ($66 billion) into its ailing banks after the country's real-estate boom collapsed. Many economists are warning that something similar might happen in Spain, once the local savings banks, or cajas, are hit by the full impact of the drop in house prices.
But the link between governments and banks goes beyond the direct cost of bank bailouts.
Regulators must untangle a spider's web of potential risks, from banks' exposure to their own economies through loans and mortgages, to their holdings of government bonds of highly indebted countries and those of other banks that might be on the brink of collapse.
The stakes are high. European banks have an exposure of 1.9 trillion euros ($2.5 trillion) to the government debt of other European countries, according to an analysis by economists at the Organization for Economic Cooperation and Development published in September.
That figure of course includes the debt from relatively strong economies like Germany, France and the Netherlands. But with a growing number of economists saying that a default or restructuring of debt from Greece, Ireland or Portugal is almost inevitable, markets are fretting more than ever over what a sharp cut in the value of these governments' bonds might mean for banks throughout the region.
Many experts nevertheless doubt that regulators will go all the way in February.
In this summer's stress tests, only 7 of 19 European banks failed; and they were asked to raise a total of 3.5 billion euros. By contrast, stress tests conducted in the U.S. in May 2009, forced 10 of the 19 banks scrutinized to boost their capital levels by almost $74.6 billion.
The main reasons, analyst say, was that the European criteria for the stress tests were far too optimistic and that their design encouraged national regulators to make their banks look better.
The EU has said that, in contrast to the earlier tests, regulators will this time look at banks' so called liquidity positions, that is, how quickly they can turn their assets into cash and not just how much those assets are worth. That's important because for banks, which rely heavily on short-term capital, funds can dry up overnight when there's a crisis.
But experts say the new tests also need to include the possibility of a sovereign default — a government actually failing to pay off bonds as they come due — which would lead to much bigger losses on bond holdings, or so-called haircuts, than were envisaged in the previous test.
To make the tests credible, a 20 percent haircut "would just about do it," said Geoffrey Wood, a professor at the Cass Business School in London and a former adviser to the Bank of England on financial stability.
At the same time, regulators have to be more realistic about unemployment rates — which can affect the ability of consumers and businesses to repay loans — and drops in real estate prices, which can mean mortgage defaults.
The decline in house prices estimated by some national regulators in the summer tests was "trivial," said Wood.
The Greek worst-case scenario, for instance, only expected a 2 percent fall in house prices — an estimate that seems optimistic for a country whose economy is expected to shrink 4.2 percent this year and a further 3 percent next year.
But the criteria weren't the only problem, says Nicolas Veron, a financial services expert at Brussels-based think tank Bruegel. In contrast to the U.S., where the Treasury and the Federal Reserve were in charge of the stress tests, Europe's tests were conducted by national regulators.
With banks competing across Europe, the lack of a strong central authority, "creates an enormous incentive for these countries to sugarcoat the results," Veron said.
No country wants to be the first to expose the weakness of its banking system, for fear that business will move to other states and its banks will be swallowed up by foreign institutions.
"It's game theory 101," said Veron.
Since the summer, EU governments have agreed to set up a central European Banking Authority, which will succeed the Committee of European Banking Supervisors that oversaw the last stress tests.
But the EBA, which will be up and running by start of 2011, won't have the staff or the authority to second-guess what the national authorities tell it, said Veron. "At this point I see nothing that reassures me that what has not worked the previous two times will work this time."
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