EU Stress Test Shifts from Frankfurt to Berlin

The announcement that euro area’s banks are in the strongest shape in years is good news for a region that has had little to crow about lately. But the clean bill of health that the European Central Bank delivered on Sunday won’t by itself provide the spark to revive the region’s economy.

Hopes were high at the start of the year that the ECB’s big banking review would end doubts about the system’s health once and for all and break the link between weak banks and indebted sovereigns that was the root of the zone’s debt crisis. Two earlier tests by the London-based European Banking Authority, in 2010 and 2011, had failed to reassure markets, prompting European Union leaders to give the job of banking supervision to the ECB as a last resort.

Since January, the central bank has had some 6,000 supervisors and outside consultants scrutinize the books of 130 banks to assess the quality of their loans and adequacy of loss provisions and ensure they had enough capital to withstand a fresh crisis. And although a few German voices, including permabear Hans-Werner Sinn, criticized the exercise for failing to assess the potential impact of deflation, the exercise didn’t lack for rigor. The ECB tested banks for an adverse scenario that involved a recession that would reduce output by 6.6 percentage points below the baseline trend by 2016 and depress inflation to just 0.3 percent.

Fully 105 of the euro area’s 130 large banks passed the test outright. Another dozen banks had modest capital shortfalls but managed to close them — either by raising capital or shedding assets — this year. That left 13 banks facing a combined capital shortfall of €9.5 billion ($12 billion). The single biggest, Italy’s Monte dei Paschi di Siena, will have to come up with €2.1 billion. In most cases, the banks will have nine months to take corrective action after submitting plans to the ECB by November 10.

The results should come as little surprise. Banks have been acting with increasing vigor to shed assets and raise capital since the ECB announced plans for the asset quality review and stress test last year. Since June 2013, the 130 banks have raised €60 billion in fresh equity, sold €32 billion of contingent capital bonds (considered to be like equity), generated an additional €44 billion of capital through retained earnings or provisions and sold assets that had the effect of boosting banks’ capital ratios by another €67 billion. The banks started the exercise with a common equity tier-1 capital ratio of 11.9 percent on average, well above the ECB’s target minimum of 8 percent and the actual current regulatory minimum of 4 percent.

Whatever doubts may linger, the exercise has gone a long way toward reducing the risk of a banking implosion. That’s a welcome result, but it’s far from sufficient to jump-start the euro area’s economy. With inflation running just 0.3 percent, growth in France and Germany stalling and Italy now in a triple-dip recession, there’s little demand for credit, regardless of supply. That’s why banks made such paltry use of the ECB’s targeted longer-term refinancing operations last month. Central bank purchases of asset-based securities and covered bonds are almost certain to disappoint too. Even full-blown quantitative easing, which markets are clamoring for, is unlikely to move the needle. When the U.S. Federal Reserve began QE in 2008, long-term Treasury yields were above 3 percent. Today Germany’s benchmark ten-year government bond yields a minuscule 0.86 percent, and spreads on other EU sovereigns have fallen sharply. It’s hard to see how ECB purchases of sovereign bonds can bring yields down much lower.

Governments — led by Chancellor Angela Merkel’s in Germany — hold the keys to restoring confidence and reviving growth. France and Italy continue to stall on much-needed structural reforms, in large part out of political timidity but also because such measures depress growth in the short term. Germany is the one country with the scale and the capacity to take stimulative action. The country ran a balance of payments surplus of $274 billion, or 7.5 percent of gross domestic product, last year. That was nearly $100 billion more than China’s surplus, and more than three times as large as that in terms of GDP. The euro area can’t get back to health — and its troubled members can’t get their debts under control — if its biggest economy continues to produce far more than it consumes.

The outlines of a potential compromise have long been in the air: some kind of fiscal relaxation from Berlin along with credible reform commitments from Paris and Rome. So far, Germany shows little sign of giving in. Finance Minister Wolfgang Schäuble says the government is looking at ways to spur private investment but will stick with plans to achieve a balanced budget in 2015. The coming weeks could see a showdown. The European Commission of José Manuel Barroso is almost certain to reject the draft 2015 budgets from France and Italy when it holds its final meeting on October 29, raising political tensions in the bloc. His successor, Jean-Claude Juncker, wants to stimulate the economy with a €300 billion package of infrastructure investment, but that will require firm backing from Germany.

The euro area’s biggest problem today is a lack of growth. That is making it virtually impossible for companies and households to reduce their debt burdens and is undermining confidence in EU institutions — and potentially the euro. That’s why the stress test that really matters is the one between Berlin and other EU capitals.