The European Central Bank (ECB) lays its credibility on the line next week when it outlines how it will test the health of top Euro zone banks, a crucial step in rebuilding confidence after two similar exercices flopped.
However, running "stress tests" with the rigour that earlier discredited European Union checks lacked is likely to expose serious problems at a number of banks which the ECB will start supervising next year - and the Euro zone still has no common mechanism for recapitalising the weakest lenders.
While the Euro zone economy cannot recover fully without broad confidence that its banking system is sound, the ECB may find itself walking a fine line as European banking union remains incomplete.
"The tests have a very strong responsibility in showing what the weak parts of the system are, but at the same time they need to safeguard the integrity of the system as a whole," said Alberto Gallo, head of European macro credit research at Royal Bank of Scotland.
"If it works well, it will really be a game changer."The ECB will take over regulating about 130 banks from national authorities under the first stage of the European banking union. This project aims to ensure that never again must taxpayers stump up billions to rescue lenders, as they did during the financial crisis which erupted in 2008.
Blunders littered the last two stress test exercises, such as giving Irish banks a clean bill of health months before they dragged the country to the brink of bankruptcy.
Therefore, ECB wants to unearth risks buried in balance sheets before it starts supervising the banks which have assets that are valued at more than ^30 billion or exceed 20 per cent of their home country's economic output, plus those lenders that have been rescued with EU funds.
Next Wednesday, the ECB will reveal how it plans to run next year's tests on these banks directly under its watch. The review will also form the basis for a Europe-wide check later in 2014.
If successful, the exercise will show which banks should already be strong enough to withstand a future crisis and which need to raise more capital. The International Monetary Fund estimates Spanish and Italian banks alone face ^230 billion of losses on credit to companies in the next two years.
Elusive agreement
EU finance ministers approved the shift in regulatory powers to ECB on Tuesday. But after months of argument, agreement remains elusive on the second stage of banking union on how to salvage or wind down banks that run into trouble.
Many banks may be unable to raise capital on their own and the Euro zone crisis showed that often even national governments cannot afford to stage rescues. Apart from Ireland, even Spain - the bloc's fourth biggest economy - had to take international help to tackle its banking problems.
France, Spain and Italy want an immediate joint commitment by all 17 Euro zone countries to stand by weak banks regardless of where they are.
Germany, which fears it would end up picking up most of the bill, dug in its heals with Finance Minister Wolfgang Schaeuble saying such a step was "not probable for the time being".
Nevertheless, ECB is pushing ahead with the review and results are due in October next year, shortly before the Single Supervisory Mechanism under the roof of ECB starts operating in November.
"The asset quality review and the stress tests are key for the recovery in Europe," Gallo said.
Bad loans loom large
The number of banks directly under ECB might rise as the list will be based on balance sheet size at the end of this year. National supervisors will continue to be in charge of smaller banks, although the ECB can intervene if necessary.
To avoid banks concealing the state of their businesses behind local conventions, as in previous tests, a single definition for bad loans will be applied, as outlined by the European Banking Authority.
Italy has the most conservative calculation of non-performing loans, Spain and France have comparatively neutral definitions, while Germany is slightly easier in its recognition of restructured loans and Britain has the most flexibility in classification, Nomura analysts said.
A single definition will make it easier for investors to compare banks from country to country.
The review will focus on "problem categories" of loans in individual countries, looking at areas such as shipping, commercial real estate and mortgages in some markets. In Germany, for example, banks like Commerzbank, HSH Nordbank and NordLB have high shipping exposures. Real estate will be more significant for Spanish, Italian and Portuguese banks.
Banks have to show whether they have classified their loans correctly and set aside enough cash to deal with debts unlikely to be repaid - the Euro zone recession has left many households and companies unable to service their loans or mortgages.
Banks' capital base is likely to be measured against the global Basel-III standards, which means they must hold at least seven per cent of risk-weighted assets plus an additional capital surcharge for lenders whose health could affect the wider banking system.
A crucial question is how banks' holdings of sovereign bonds will be treated, following a push by the German Bundesbank to reflect more adequately the varying degrees of risk attached to bonds issued by different governments.
As banks do not have to hold capital to back their sovereign debt holdings under Basel-III, ECB is unlikely to address the issue in its asset quality review.
It could, however, feature in more forward-looking tests run by the EBA, which examine how banks would cope with scenarios such as a collapse in economic growth, a rise in interest rates or more difficult funding conditions.
A Morgan Stanley survey of investors showed 41 per cent expected Euro zone banks to raise between 20 billion and 50 billion euros in new equity as a consequence of the tests.
