The impact of Europe’s stress tests

Similar to efforts in the United States five years ago, the rigorous stress testing of banks in Europe is key to building a floor under the region’s economy and thus providing the basis for a more durable recovery. That is the good news in yesterday’s release of data by the European Central Bank.

But for the assessment to be fully effective, Europe needs to do more, including finish work on the four legs of successful economic integration.

The stress tests (formally called the AQR, for asset quality review) matter because banks play a disproportionately important role in Europe in channeling funds to productive activities. Despite significant capital increases in the last few years, doubts have remained about the health of their balance sheets and operations, and their role as effective intermediaries.

The review is also essential for the region’s transition to a single and uniform system in which the ECB, the EU’s most credible official entity, assumes much greater responsibility for supervision and regulation.

The AQR, by providing a comprehensive snapshot of the banking system as of the end of December 2013, will help overcome information asymmetries - with some parties having access to a lot more or a lot less information than others - and the uncertainties that come from the lack of credible and comparable data. All of this tends to inhibit higher investments, growth and financial stability.

By releasing enough details, the ECB would allow analysts to subject the stress tests to their own assumptions about regional economic prospects, default rates, bank responses and so on.

How about the immediate impact? At a minimum, look for the stress tests to force failing banks to raise capital, shed assets and, in some cases, merge into more solid platforms. But the impact should go beyond this.

Expect the AQR to allow for greater differentiation between good and bad investments, thus rewarding the better-run banks and giving others more of an incentive to get their act together. With the bigger picture perspective, it will also help lift the general cloud of uncertainty and thus enhance the flow of capital to the banking sector as a whole.

Each of these effects can lead to more sustainable growth and reduce the threat of financial instability - as witnessed after the stress tests in the United States, helping it to outperform Europe in recent years. But as in the United States, the full benefit of the review in the short term will be held back by delays in carrying out pro-growth structural reforms and infrastructure investments, as well as rebalancing an overly restrictive fiscal stance that lacks both responsiveness and flexibility.

Over the longer term, and because several European countries are part of a single monetary union, unleashing the full potency of the AQR will also require further progress on the lagging components of successful regional economic integration.

With the actions led by the ECB, Europe is putting in place another element of the banking union required to run a successful eurozone. It is now the politicians’ turn to attend to the remaining two legs of the four-legged stool: greater fiscal and political integration.

The author, the chief economic adviser at Allianz SE, is chairman of Barack Obama’s Global Development Council.

by Mohamed El-Erian