The European Central Bank (ECB) has published it’s criteria for a comprehensive assessment of banks’ balance sheets. This move represents the opening salvo in what should be the final round of negotiations in Brussels over the financial backstops needed to ensure that the ECB’s review of banks won’t trigger a new crisis.

With the help of national regulators and third parties―including the consultancy group Oliver Wyman―the ECB will undertake a comprehensive asset quality review, followed by a series of stress tests in the coming year. This is the final chance to clean up banks with so-called legacy assets and restore confidence in the European banking system. At stake is not only the credibility of the ECB, but also the fragile European recovery.

Without sound banks, the European economy will not grow―at least not enough to significantly reduce unemployment.

This is why by year’s end the ECB needs a firm and detailed commitment by member states on their readiness to recapitalize or even wind down banks if needed. Given the widespread bailout fatigue and need to address the question of moral hazard, many member states, lead by Germany, are deeply reluctant to ask taxpayers to rescue banks once again. Instead, they want to force shareholders and creditors to almost entirely shoulder the burden―should it arise. The fiscal backstops, either national or supranational, should only be viewed as a very last resort. In principle, the ECB agrees.

However, the central bank is increasingly worried about the unintended consequences of such an approach. If balancing so-called “bail-ins” and bailouts makes the latter almost impossible, rebuilding confidence in the banking system will remain an elusive goal. Yves Mersch, executive board member of the ECB, explains:

“That’s why we keep on stressing that backstops need to be put in place in time. We want to create certainty, transparency, and credibility. That in itself will already help banks to attract capital. But they may not be able to attract everything they need from the markets.”

Indeed, that is why backstops are essential and should not be narrowly viewed as a last resort. They should be deployed, if necessary, to ease the way for private capital to flow towards those banks that investors still view with some suspicion. Unless that happens, there is a risk that capital would continue to stay on the sidelines or only flow towards banks in countries with robust bailout capacities. Shareholders, bondholders and member state governments with shaky public finances would have to bear the whole brunt of recapitalization needs. The fragmentation of the Euro zone’s financial market, now partially reversed, would resume unabated.

Indeed, barring banks from accessing public funds unless losses are forced on shareholders and bondholders, currently a central building block of the EU rules for handling struggling banks, could have a destabilizing impact on the financial sector. In a leaked letter to the EU commission, ECB President Mario Draghi warns against too much rigor. “An improperly strict interpretation of the state aid rules may well destroy the very confidence in the euro area banks which we all intend to restore.”

The Commission is not this message’s only intended recipient. Indeed, Draghi issued a veiled warning to countries that host some of the most potentially problematic banks―namely France, Italy, and last but not least Germany. They should all get ready to plug capital holes in some of their banks. If governments refuse to make taxpayers’ money more readily available, the final bill―for them and the Eurozone as a whole― could be much higher.

  • K Bledowski

    The backstop for banking crises needs flexibility. Legislating bail-ins by creditors as the only solution appears too constraining. Taxpayers’ money may turn out to be a usable option in some cases. The search should be for formulas that satisfy the size and scope of Germany’s contingent liability here.