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Falling Short of Expectations? Stress-Testing the European Banking System

By Viral Acharya

Viral Acharya on flight from US treasuries

A comprehensive and decisive AQR will most likely reveal a substantial lack of capital in many peripheral and core European banks.

The Single Supervisory Mechanism – a key pillar of the Eurozone banking union – will transfer supervision of Europe’s largest banks to the ECB. Before taking over this role, the ECB will conduct an Asset Quality Review to identify these banks’ capital shortfalls. This column discusses recent estimates of these shortfalls based on publicly available data. Estimates such as these can defend against political efforts to blunt the AQR’s effectiveness. The results suggest that many banks’ capital needs can be met with common equity issuance and bail-ins, but that public backstops might still be necessary in some cases.

The Eurozone is mired in a recession. In 2013, the GDP of the 17 Eurozone countries fell by an average of 0.5%, and the outlook for 2014 shows considerable risks across the region. To stabilise the common currency area and its (partly insolvent) financial system, a Eurozone banking union is being established. An important part of the banking union is the Single Supervisory Mechanism, which will transfer the oversight of Europe’s largest banks to the ECB (Beck 2013). Before the ECB takes over this responsibility, it plans to conduct an Asset Quality Review (AQR) in 2014, which will identify the capital shortfalls of these banks.

The banking systems in the Eurozone have been severely under-capitalised since the 2007–2009 financial crisis. As a result, some banks loaded up on risky assets (and risky sovereign debt in particular). The worsening risk profile of these assets destabilised banks even further and resulted in substantial liquidity and solvency problems by the third quarter of 2011 (Acharya and Steffen 2013). Too little capital in the banking system appears to have also caused a misallocation of credit in the Eurozone, especially for small- and medium-sized enterprises, preventing a widespread economic recovery.

Read full article as published in VoxEU

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Viral Acharya is the C.V. Starr Professor of Economics and the Director, NSE-NYU Stern Initiative on the Study of Indian Capital Markets.