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Credibility Is Everything: European Bank Stress Tests, Take Two

Credibility Is Everything: European Bank Stress Tests, Take Two

Last year's European stress tests were exposed as all but pointless by the Ireland bank crisis. This time, if they are not a real test of credibility, all of Europe will pay the price.

Bank of Ireland (Goran)

PARIS – This time is for real. The stress tests scheduled to be performed on European banks over the next four months must be stringent – and there will be no third chance.

This time around, tests need to be more than just a big marketing campaign trying to convince investors that European banks are solid. Unlike the public stress tests performed on Wall Street in the spring of 2009, which they were supposed to emulate, last July's stress tests were far too mild -- and in the end, useless. The utter inefficiency of the European Union tests was underscored at the end of last year, when Irish banks -- which had all managed to squeeze over the bar -- crumbled, bringing Ireland's economy to its knees with them.

The stakes for the EU in this challenge are extremely high. In order to be credible, this second round of stress tests on banks needs to be given all the means necessary. First, the tests must test the resilience of banks in the event of a sharp macroeconomic slowdown (this already seems to be the case); then, the tests must be able to accurately evaluate liquidity risks; and finally, the exercise must envisage the creation of an immediate rescue mechanism for the institutions thought to be the weakest.

But if Europe really wants to regain market confidence, it will have to stop procrastinating on the delicate matter of the euro zone sovereign debt rating. For the moment, it seems that the exercise will not take into account the risk of a Union European member defaulting. But it will definitely have to consider debt restructuring in the case of ailing countries. It is better to admit, for example, that the Greek debt is worth 70% of its value than to deny the obvious, and let investors get away with setting their own rules. Regulators should not be afraid to do this, especially since the impact the tests will have on banks' solvency will be limited: only banks selling their debt will be affected by the restructuring.

But the decision does not only depend on bank regulators, it is a matter of European governance. Alongside the future missions of the European Financial Stability Fund, and the conditions regulating the sovereign debt renegotiation starting in 2013, efficient stress tests could ultimately prove to be one of the keys to solving the entire euro zone crisis. The European summit taking place Friday should confront this head on.

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