Stress tests may not be enough to kick-start euro zone

When European Central Bank president Mario Draghi pledged in July 2012 to do "whatever it takes" to preserve the single currency there was little doubt Italy was on his mind. Mounting pressure on Spanish and Italian bond yields had raised serious concerns about the health of some of the euro zone's largest economies. Italy, the bloc's third largest economy, was too big to fail.

Yesterday it was back in the spotlight. Nine Italian banks failed the ECB's stress tests, with Banca Monte dei Paschi found to have a capital shortfall of €2.1 billion despite having raised capital this year.

Sensitive time Concerns about the health of the Italian banks have been circulating in financial and euro zone circles for months. But fresh proof of the fragility of Italian banks has emerged at a sensitive time for the government of Mario Renzi, which is

locked in a battle with the European Commission over Italy's 2015 budget.

The commission has until Wednesday to reject the budget of any euro zone country and delivered preliminary warnings to France and Italy last week. Italy's colossal public debt and anaemic growth levels have not shown signs of improvement even as the euro zone sovereign debt crisis has abated.

While all eyes will be on the performance of Italian financial stocks today, overall the relatively low capital shortfall revealed by the ECB’s comprehensive assessments is the defining outcome of the tests.

The €10 billion or so shortfall in part reflects banks’ preparedness – banks that had been in close contact with Frankfurt throughout the process had been raising capital in anticipation of the results, though some analysts are likely to question the ECB estimates’ credibility.

Also, the stress tests have taken place in the context of a much more benign market climate than in previous years. Capital is much more readily available to banks now and investor appetite is back. This is good news for taxpayers. Given the amounts involved, it is highly likely the capital shortfall will be met by private sources, though technically, from January 1st, the EU’s transitionary “bail-in” rules will come into force. They will oblige banks to hit a hierarchy of creditors before using national bailout funds, and even large depositors.

While declining to comment on how the capital shortfalls would be met by banks, ECB vice-president Vítor Constâncio said yesterday “fixing” the shortfalls was “doable.”

The other issue of concern to taxpayers is the likely impact of the stress test results on banks’ willingness to lend. Constâncio yesterday conceded banks may have withheld lending in anticipation of the review.

“This exercise led banks to be careful what they were doing with credit. They wanted to be as prepared as possible to pass this exam,” he said.

Riskier credit decisions

Now that the stress tests have been completed, lenders may now be more willing to take riskier credit decisions, he suggested: “The banks will certainly be much more comfortable to take decisions.”

He twice stressed lending would pick up only “provided there is enough aggregate demand”. With euro zone inflation at 0.3 per cent, and activity across the euro zone slowing at an alarming rate, demand is something the euro zone is lacking. A relatively clean bill of health for its banks by its supervisor may not be enough to kick-start the troubled euro zone economy.