How Safe Are Europe’s Banks? Right Now, It’s Hard to Tell

(The Bloomberg View) -- The departing head of the European Banking Authority has issued a warning over the state of the EU's so-called stress tests, which are meant to show whether banks have sufficient capital to weather bad news. Andrea Enria, who'll shortly become head of the supervisory arm of the European Central Bank, is right that the system needs reforming, but his suggestions aren't enough to fix the problem.

Since 2011, the EU authorities have run four stress tests, including one this year. The exercises led banks to strengthen their capital buffers, but investors remain skeptical. The authorities have sometimes given banks a clean bill of health or required no more than mild remedial action only to see them get into trouble soon after. The implication is that the tests aren't stringent enough.

Enria's main idea is that regulators should disclose the results of the tests alongside any required supervisory action. That's a good idea: It would bring Europe into line with the U.S. Federal Reserve and would make the process more transparent, and hence more rigorous.

The EU system also differs from the Fed's approach in another way: It relies on banks' internal models to judge whether capital is adequate, rather than using models of its own. The U.S. stress tests have been criticized for being too soft — but the Fed's basic approach is better, because banks can retrofit their models to make their balance sheets look less risky. When Enria takes charge of the euro zone's Single Supervisory Mechanism next year, he should push for the ECB to stop relying on the banks.

Beyond that, Europe needs one more thing — a less forgiving approach. Excessive non-performing loans still burden the balance sheets of several banks in southern Europe. In dealing with this, the dilemma for the ECB is obvious: If it says that non-performing loans should be immediately written down, this could trigger a cascade of demands for additional capital, which could in turn alarm investors and cause financial instability. On the other hand, tolerating excessive non-performing loans undermines the credibility of the system, running the risk of greater instability in future.

Europe needs to adjust the balance. Now and then, despite regulators' best efforts, banks will go bust. This should not be deemed intolerable: Failure is part of a well-functioning market economy. Sometimes, to be sure, dealing with the consequences of a bank failure will require state support, and in those cases — after imposing losses on shareholders and bondholders — the euro zone should be ready to use funds from its European Stability Mechanism. But persistently turning a blind eye to zombie banks is not the answer.

Forbearance can avoid the painful consequences of letting a bank fail — for a while, but not indefinitely, and only at the cost of undermining the system as a whole.

Editorials are written by the Bloomberg View editorial board.

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