Here’s Why the ECB Is Going Tough on Eurozone Banks

European Union Flag

The European Central Bank has formally announced its review of the region’s commercial banks that will occur over the course of the next year, Reuters reports.

In the release concerning the comprehensive assessment, the ECB has declared that the initiative will be comprised of three separate phases. The first step will be a supervisory risk assessment, in which the bank will examine the risk profiles of banks in the region. The second step will be an asset quality review that will scrutinize the asset side of banks’ balance sheets, and the final phase will be a series of stress tests to be conducted by the central bank in conjunction with the European Banking Authority.

Hitting major banks in all of the eurozone’s large countries, the review is expected to cover some 85 percent of the area’s banking activities. Beginning shortly with the risk assessment, the entire process is projected to take approximately a year to complete, meaning that it will be finished in time for the ECB to being its supervisory role of banks in the eurozone through the Single Supervisory Mechanism next November.

In the press release that accompanied the announcement, Mario Draghi, the chief of the European Central Bank, was quoted as saying that, “We expect that this assessment will strengthen private sector confidence in the soundness of euro area banks and in the quality of their balance sheets.”

This would seem to indicate that the review will error on the side of stringency than on the side of laxness. Indeed, it has already been declared that banks will be required to hold 8 percent of their assets in capital, up from expectations of a 7 percent threshold.

Past reviews failed to uncover holes in the banking systems of countries such as Spain and Ireland, but a review that is too tough may serve to weaken confidence by exposing too many problems. Upon hearing the news, many European banks saw their stock prices plummet, with banks in Spain and Italy being hit particularly hard. Most German banks did not take as big of a hit, possibly because many of them have already been subjected to review on a national level.

One issue that is now being brought up is who will pay to resolve any holes that the review finds. While some banks may be able to raise private capital in order to bring themselves in line with regulations, others may not be so lucky, especially if the review process uncovers significant gaps in their balance sheets. Many officials, including Mario Draghi, have called for the establishment of a central fund to provide access to capital for banks that need to raise money in the wake of the review.

Another problem is the question of how the review will treat government debt. Under the official EBA regulations — which the review is claiming to adopt — government debt is treated as risk free. However, in countries such as Italy, where some have speculated that sovereign debt accounts for over 10 percent of banks’ assets, this could seriously call into question the efficacy of the stress tests. Just as in with the stringency of the review, the ECB must continue to tread a fine line in setting out the parameters for its initiatives.

Don’t Miss: 9 States With the Most Economic Opportunity.

More from The Cheat Sheet