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FRANKFURT, Germany – Europe's biggest banks are facing a day of judgment as the European Central Bank prepares to unveil the results of a yearlong search through the dark corners of their finances.
It's a step that comes none too soon for the struggling economy of the 18-country eurozone.
The ECB review to be unveiled Sunday seeks to identify banks that are too weak to lend to businesses or make it through another recession and force them to strengthen their finances. It includes a detailed look at 130 banks' loans, holdings and investments, as well as a so-called stress test that simulates how banks would fare in a deep economic downturn.
Those that fall short in the tests will have to raise more money — and could have to restructure or be sold to stronger partners.
The purpose: leave banks in better shape to lend to companies, enabling businesses to expand production, hire people and get the economy growing again.
Here are key takeaways.
NEW SHERIFF IN TOWN
The ECB becomes Europe's top banking supervisor in November, taking over from national regulators regarded as often too soft on their troubled banks. As a result, the ECB has a strong incentive to uncover any unpleasant surprises hiding in the weeds of the banking system before taking responsibility.
The ECB's reputation is at stake as well. Previous tests by a different EU agency in 2011 and 2010 lost credibility after banks that passed needed to be bailed out months later. A key difference this time is that the ECB has been able to take a detailed look at bank's loan books — information not available for the earlier tests, which relied on banks to say what their assets were worth.
THE GOOD, THE BAD AND THE UGLY
The test results could cause some market turbulence for banks in the following days and weeks, as lenders that do poorly in the review scramble for money.
Those banks will have two weeks to show the ECB how they're going to raise cash. Typically they would issue new shares. They then have six to nine months to actually raise the money. If investors are reluctant, the banks may have to turn to their national government for bailout money.
Analyst Jacob Funk Kirkegaard at the Peterson Institute for International Economics says "it would be very useful for the ECB to essentially shut down at least one bank, to show the markets and the community that they have the willingness and the power to do so."
Kirkegaard said the slew of data could mean a "material re-pricing" of bank stock values from Friday's close during the days after the test results. That could unnerve investors in the short term — but strengthen the system in the end.
"I think you could easily have banks that may have passed the stress tests and are not ordered to raise more capital — but find themselves under significant market pressure to do so. And that to me is the criteria for success," he said.
Faced with the public exposure of their financial problems, some European banks started coming clean months ago on the amount of bad investments they were holding on their books.
Michael Schroeder, professor of asset management at the Frankfurt School of Finance & Management, said that banks started adding capital and shedding risky loans and investments in the year leading up to the end of 2013, the date the ECB review takes as its starting point.
Draghi has said the banks it will supervise have since last summer strengthened their finances by around 203 billion euros ($258 billion) by issuing stock, bonds that convert to stock, holding back earnings and selling assets.
"The first signs that we see are that it was an incentive to improve," said Schroeder. "Therefore I would say it's already a success."
EUROPE VS AMERICA
Unlike in the U.S., most European companies get their financing from banks, not from selling bonds. That makes banks key to the economy. And the European banks that are still nursing losses and bad investments left over from the financial crisis may be less able to lend.
The U.S. showed the importance of acting to cleanse the banking sector of bad investments.
The U.S. Treasury pushed banks to strengthen their finances as early as 2009. That early effort is cited as one of the reasons why the U.S. economy has rebounded more quickly from recession. Europe's economy showed zero growth in the second quarter, after four quarters of meager growth, with unemployment of 11.5 percent. The eurozone desperately needs growth and lower unemployment to keep climbing out of its troubles with too much government debt.