CNBC Comment: Euro banks await critical stress tests

EUROPE’S banks are facing one of their most difficult periods since the credit crisis began. Tomorrow the European Central Bank (ECB), is expected to outline the criteria for its Asset Quality Review (AQR). This is the highly-anticipated stress test of banks’ balance sheets, and will be the first time the ECB outlines just how stringent it will be, as it takes responsibility for supervising Eurozone banks next year.

It’s in the interest of the ECB, Europe’s banks, and ultimately all us that the review is as forensic as possible, with banks sticking to one single rule book. With Europe-wide banking union looming, savers in economies like Germany may be concerned that they could end up forking out more to keep weaker economies like Greece afloat if the review is incomplete.

Yet unfortunately, it will be difficult for even the most Pollyanna-ish central banker to trust everything banks say about their prospects. The process of bailing out Greece, where hidden shortfalls kept appearing, has taught them to be cynical. It’s also not long since it emerged that one of the key figures in the bailout of Anglo Irish Bank, which helped bring the Irish economy to crisis point, said he had “picked [the bailout figures] out of my arse”. And the full bill for misdeeds committed years ago over issues like Libor has yet to unfold.

Many banks are also more inextricably linked with the success of their base countries’ economies than before. Take Portugal, where the three biggest banks used cheap loans from the ECB to raise their exposure to the country’s bonds by 16 per cent in the first quarter of 2013.

But now banks have a chance to help restore their reputations. They have to be upfront about the true extent of their non-performing loans, and maybe even call in more of them. Otherwise, the European economy risks extended zombification, where firms continue to pay off the interest on their loans, but don’t repay capital or grow their business. This was one of the problems which plagued Japan during the 1990s, and its effects are still felt today.

Banks may need to raise more capital to ensure that the ratios demanded by the ECB are met. Previous European banking stress tests have been rightly criticised for erring on the side of optimism. This time, the ECB has to be honest about how bad growth figures could get, and how negative banks’ exposure to sovereign debt could be. If not, further financial turbulence or even a third recession within a decade could be on the cards.

Catherine Boyle is a staff writer for CNBC.com, and on air contributor for CNBC. Follow her on Twitter: @cboylecnbc