European banks still in trouble

The European Central Bank's (ECB) stress test, billed as the most stringent audit of eurozone banks ever undertaken, has given most banks a clean bill of health. But it didn't do much to dissipate fears about the health of Europe's economies.

Europe's major stock markets rose slightly on Monday, but when disappointing data on German business confidence was released, shares dipped again.

"The ECB's motivation for this test was to show that it takes banking supervision seriously," said Martin Faust, economics professor at the Frankfurt School of Finance and Management. Starting November 4, the ECB will be supervising the biggest banks in the eurozone - a potential conflict of interest with its role of conducting monetary policy.

"There were doubts that the ECB would be less strict in its supervision, and instead try to prop up the financial system as a whole", Faust told DW. "So it was important for the ECB to send a clear signal to the markets and the banks."

Fresh capital for banks

In the run-up to the test, European banks had bolstered their balance sheets with 200 billion euros ($254 billion) in fresh capital, said Andreas Dombret, member of the executive board of the Bundesbank, Germany's central bank. "When so many banks take up so much capital, the financial sector as a whole becomes safer, which is good for everybody," Dombret said.

25 banks have failed the test, which looked at their balance sheets up to December 31, 2013. Since then, 12 bank have recapitalized. The remaining 13 institutions now have to submit plans on how they intend to fill the gaps.

But the audit failed to bring up "real surprises", Hans-Peter Burghof, finance professor at Hohenheim University, told DW. "It's confirmation that some banks in Europe's north did do their jobs, while some banks in the south didn't."

The fact that nine Italian banks flunked the test is a worrying sign, according to Burghof. "It shows that Italy is not forcefully tackling the problems - not only in the banking sector, but also with regard to the national budget and the labor market." If Italy doesn't solve these issues, "it will become a major problem for Europe," Burghof said.

A bigger pile of bad loans

The ECB also found that the pile of shaky or non-performing loans in European bank's balance sheets is much bigger than previously assumed and totals some 880 billion euros.

Critcs worry that these bad loans will eventually end up with the ECB, which might purchase them from banks as part of its recently announced program to buy asset backed securities (ABS). Economist Martin Faust disagrees. "It can't be that banks just pass on those loans to the ECB," he said. "The central bank has made it very clear that it will only buy high-quality ABS - which doesn't really help banks sitting on bad loans."

The sheer amount of bad loans doesn't exactly make the European banking sector attractive, and neither does the low profitability of many banks. "In many countries, we still have too many banks," Faust said.

The limits of stress tests

However, the test results do not give a clear indication of which banks might go out of business in the future. The stress test scenario assumed a bust in real estate prices, among other things. "But it all depends on whether that scenario will actually take place," said Faust.

The ECB's scenario did not include another haircut for Greece, so banks did not have to back up their exposure to Greek sovereign debt with equity. In 2012, private investors had to write down half of their loans to Greece, and many experts believe another haircut is likely.

Moreover, European sanctions against Russia had not yet been in effect when the test was designed, and prospects for the eurozone economy have changed. "The economic situation looks worse now than half a year ago," said Faust.

Back in 2010, another eurozone-wide stress test clearly failed to identify troubled banks. All Irish financial institutions passed the test. Just four months later, they had to be rescued by the government.