Shock therapy

FROM high-rises looming over the dusty plains of Spain’s ghost cities to empty cargo ships bobbing idle in the Singapore Strait, European banks financed billions of euros’ worth of dud assets in the boom times. Yet as boom turned to bust, Europe’s banks largely failed to write down loans that will never be repaid. Instead they have limped on, too feeble to make new loans to growing businesses and too cosseted by politicians and regulators to take choices that might hurt their shareholders but benefit their economies.

This week the European Banking Authority, which co-ordinates national regulators, took a big step towards forcing banks to clean up their balance-sheets. It revealed details of the test it will administer to assess whether Europe’s banks can survive an economic shock or a downturn in markets. The previous set of “stress tests”, conducted in 2011, proved an embarrassing whitewash: some banks that had passed with flying colours came crashing down just a few months later. That left investors uncertain about banks’ true health, which in turn made it hard for banks to sell shares or issue bonds.

The tests announced this week will be more rigorous, modelling a sharp rise in bond yields and a 2.1% fall in economic output over three years, compared with a 0.4% drop over two years in the 2011 tests. Some countries, Britain among them, will add still gloomier scenarios to this, such as a deep fall in house prices. Holdings of sovereign bonds will also be treated less kindly than in previous tests, which maintained a fiction that almost all of them were worth what banks had paid for them. All this will come on top of a thorough exploration of the mustier corners of the vaults of banks in the euro area, in the form of the “asset quality review” (AQR) to be carried out this year by the European Central Bank.

The main reason to expect that this year’s stress tests will be different, however, is that they are rowing with the tide rather than against it. Huw van Steenis, an analyst at Morgan Stanley, points out that European banks are writing off bad debts and raising some €35 billion ($49 billion) in capital in order to pre-empt the results, which are due in October, along with those of the AQR. That should help to make the process genuinely cathartic this time, he thinks. If only it had happened years ago.