The global market turmoil is a vivid reminder that the European crisis didn't go away - it has just been lying dormant.
One big reason is that authorities never dealt with the dysfunctional banking system. And investors are increasingly concerned that more problems might be lurking in the banks' books.
The European Central Bank is trying to restore confidence with a deep dive into the banks to determine which are in good shape, which need to shore up their finances and which should be shut down. But the results, which are set to be released next weekend, may further rattle the markets if banks unexpectedly have to write down bad loans and quickly raise capital.
Officials say that the short-term pain is necessary to put the European economy back on track. Regulators in the United States forced a similar catharsis on American banks in 2009, helping set the stage for the current recovery.
The fragmented euro zone took a more timid approach. A review in 2011, conducted by another regulator, gave passing grades to banks in Belgium and Portugal that later imploded, casting doubt on the stability of the entire European financial system. Europe is paying the price. The uncertainty has made it difficult for banks to raise funds, creating a severe shortage of credit in some regions. Since businesses cannot obtain loans to invest in equipment or hire people, growth is at a standstill and unemployment remains high.
The best way to create confidence "is to recognise loans that are bad and write them off, " said William White, the former economic advisor to the Bank for International Settlements, the bank for central banks. The risk in not doing so, he said, is a cycle of stagnation like in Japan.
Doubts, too, persist about whether the ECB president, Mario Draghi, will make the bold moves necessary to revive the moribund economy and combat the deflationary trend. While he has unveiled an aggressive plan to buy bonds and pump money into the economy, details have been limited. That vacuum has only fed market concerns about the weakness in the global economy.
"You could argue the falloff of the Euro zone economy is at the epicentre of this," said James W. Paulsen, chief investment strategist at Wells Fargo Asset Management. With the current weakness, investors will now be paying close attention to the verdict of the bank review. "Three or four weeks ago, no one in the US would have cared," he said.
Europe's new banking overseer, Daniele Nouy, has vowed that the ECB bank tests will be tough.
The review is part of a broader effort to create a uniform system of regulation for Europe's biggest banks, replacing a country-by-country patchwork of supervision that the financial crisis exposed as woefully ineffective. The new pan-European regulator, the so-called Single Supervisory Mechanism that will officially take charge on November 4, has the broad powers to curtail risky behaviour and impose penalties.
The head of the group, Nouy, a lifelong civil servant steeped in esoteric banking rules, has been on a hiring spree, helping expand a small army of civil servants and outside consultants to scrutinise banks' books. An estimated 6,000 people are involved in the review.
Compared with previous efforts, the ECB is taking a more comprehensive look, sifting through about 135,000 loan files at 130 of the largest banks in the Euro zone as well as Lithuania, which will become the 19th country in the currency union next year. That amounts to 85 per cent of banks' outstanding loans and other assets, according to the ECB.
The banks will also undergo a so-called stress test to see if they could withstand a major recession, bond market panic or other adverse situation. The ECB has deliberately kept some of the methodology secret, to prevent banks from trying to manipulate the results.
Investors "will know what is in the balance sheet of European banks," Nouy said in an interview. "I am totally confident about that."
The main goal is to expose so-called zombie banks, lenders that have covered up deep problems by issuing new credit to troubled borrowers rather than allowing them to default. Lenders in Italy, Greece and Portugal are under scrutiny, given the weakness in those countries. Banks with a heavy concentration in certain industries, like commercial real estate, also face pressure.
For example, HSH Nordbank, a lender in Hamburg, has been hit hard by huge loans it made to the depressed shipping industry. The bank's position is considered particularly perilous because its options are limited if the E.C.B. finds a capital shortfall. HSH does not have a stock market listing, so it cannot sell additional shares, a standard way to raise more money.
HSH Nordbank declined to comment. But a person with knowledge of the E.C.B. examination said the bank had enough capital to pass the asset quality review.
Pressure from E.C.B. auditors has already helped uncover grave problems at one bank, Banco Espírito Santo in Portugal, which collapsed in August in the face of fraud accusations. The specter of E.C.B. scrutiny has also prompted a scramble for new capital to provide bigger cushions against potential shocks. Banks including Deutsche Bank of Germany and Monte dei Paschi di Siena of Italy have raised 200 billion euros, or $256 billion, since last summer, according to an E.C.B. estimate.
To truly clean up the system, Ms. Nouy and the rest of the E.C.B. have to be willing to force some harsh medicine on the banks - and come to a consensus on those decisions. That hasn't always been easy, at least based on Cyprus's experience.
By 2013, the E.C.B. had approved more than €9 billion in loans made by the country's central bank to its second-largest financial institution, Cyprus Popular Bank. The money flowed to the institution, which later changed its name to Laiki Bank, despite objections by one top official who said it was insolvent, according to previously undisclosed minutes of meetings held by the E.C.B.'s decision-making arm.
The minutes, which cover E.C.B. governing council meetings from May 2012 to January 2013 and were reviewed by The New York Times, highlight stark divisions between Germany, an economic powerhouse, and other countries. The head of the Cyprus central bank at the time, Panicos Demetriades, said that letting Laiki fail risked a larger market panic. His colleagues - save for Jens Weidmann, the hawkish head of Germany's Bundesbank - agreed.
Mr. Weidmann said that the value of Laiki's collateral had been inflated and exposure should be reduced, according to the minutes. Providing money to Laiki, he said, would violate a core tenet of the E.C.B.
"It was not the governing council's job to keep afloat banks that were awaiting recapitalization and were not currently solvent," Mr. Weidmann said at a meeting in December 2012.
Two months later, Laiki folded.
In a statement, the E.C.B. noted that such aid was the responsibility of national central banks, although the central bank's governing council retains veto power. The E.C.B. said it was not acting as bank supervisor and "fully relied on the assessment of the Central Bank of Cyprus."
"To draw conclusions about the E.C.B.'s future banking supervision role" based on the Cyprus aid "is tendentious," the central bank said in a statement.
Ms. Nouy, who began work at the E.C.B. on Jan. 2, after the Cyprus episode, said the central bank was now better equipped to deal with troubled banks.
The E.C.B.'s new powers will allow it to intervene in bank management in ways it could not during the Cyprus crisis. The E.C.B. would be able to block a bank from paying dividends to shareholders and use the money to build up capital. A new central authority, which will start taking effect next year, will also provide a less disruptive process for winding down banks and selling off assets.
"What is different this time is that we are much better equipped," Ms. Nouy said. "When there are crises, we will be able to organize the closure of a bank in an orderly fashion without creating domino effects."
"I'm sure that all those measures are making the financial sector safer," Ms. Nouy said. "But," she added, "I am not promising that there will not be banking crises anymore."
©2014 The New York Times News Service
