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by Vicky Pryce, Chief Economic Adviser at CEBR and author of ‘Greekonomics’, Biteback Publishing, 2013 ///

Has the Asset Quality Review (AQR) and the accompanying stress tests done their job? It is worth reflecting on it now that the excitement has died down, at least temporarily. They had been expected with a considerable holding of breath by the markets, with some analysts predicting that there would be mayhem in the markets on the Monday after their release, which was unusually on a Sunday. In the weeks that preceded the announcement, bank shares had been jittery -though partly caused by emerging market growth concerns. It is likely that expected bad news from the ECB had been priced in too.

So when the findings were finally published the reaction was muted. Some relief early on that the worst had been avoided was then followed by more worries. But overall markets in Europe survived with little change.

The reason of course was that most of the 130 banks reviewed (over whom the ECB is about to take on a direct supervisory role) had furiously and under a lot of guidance been putting their house in order over the previous year and so were deemed to be properly capitalised. Only 25 banks failed the ‘static’ tests in relation to their balance sheets as of end-December 2013 (9 in Italy, 3 in Greece and in Cyprus, 2 each in Belgium and in Slovenia and 1 each in Ireland, Portugal and France). But half of them had engaged in restructuring and capital raising activities in the months since, with support from their national supervisory institutions or had approved plans in place and were deemed to have passed the slightly softer ‘dynamic’ stress tests which took this into account.

But below the surface there were some interesting results. Most of the banks that failed the ‘static test’ were from countries in the periphery. It reinforced the general picture of a very fragile economic recovery in the Eurozone, with some countries like Italy showing signs in fact of sinking back into recession.

All countries in Europe need the banking system to play a vital role in the recovery. Yet the process of getting banks to a “healthy” state has meant continued de-leveraging over the past couple of years, with lending generally declining in most countries in Europe, and not just in the Eurozone.

This is unlikely to change in 2015. The concern of those commentators who concluded that it was a ‘whitewash’ is that much of what remains in banks’ balance sheet will get riskier and the rules tougher. The ECB has asked for only some €10 billion of extra capital into the banks but it has also demanded a very substantial increase in provisions to make up for bad loans – mainly in italy, Germany and also in Greece where the ratio of non performing loans may be as high as 40-50 per cent. That is a serious worry. The review suggested that the stock of bad loans was much higher than thought – some 18% on average for the banks it reviewed – the bank of Piraeus in Greece for example had to increase provisions by some 50% more that its original estimated provisions for 2014. Moreover the ECB has allowed for no deflation in its stress test calculations -and yet prices are falling in a number of countries across the Eurozone. Growth prospects in Europe are being reduced on a consistent basis, which will increase the difficulties of debtor countries. And stricter rules from Basle III that are coming by the end of the decade will further restrict the ability of banks to lend at the levels required to sustain growth.

What the ECB had hoped, and probably still hopes, is that at least they have laid the foundations for improving confidence in the banking system before they take on the supervision of the system shortly. In some ways they have achieved this through greater transparency and the determination to avoid unforeseen crises in individual banks by the deployment of 1,000 personnel, formed in ‘joint supervisory groups’ , one for each individual large bank the ECB will look after.

If all this succeeds in reintroducing trust into the system, encourage once again the funding of cross border transactions that will be all to the good. The jury is out. But I think the greatest impact will be if it allows the ECB to claim that now that it has complete understanding and control of the system it can limit any risks of its proposed embarking into its announced bond purchases and be allowed to finally engage in proper Quantative Easing (QE) without which the Eurozone may sink back onto recession.

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