Financial (integration) problems

By Sam Obenhaus

One of the European Unions’ lingering problems is widespread uncertainty regarding the health of its largest banks.  The European Central Bank is trying to address these persistent concerns by conducting a rigorous round of stress tests early next year ahead of the date when it assumes supervisory responsibility for the zone’s largest banks.  This will be the first time that these banks are held to the same set of standards.

Unfortunately, these stress tests also look likely to cause a new set of problems for the E.U.’s financial integration project.  In order to be credible and have their intended confidence-boosting result, they must be significantly tougher than the prior two rounds of stress tests.  But the prospect that a few banks are likely to fail the tests is causing problems.  Someone, simply put, will be on the hook to recapitalize these under-performing banks.

Fears have arisen because of a new rule that requires the conversion of subordinated debt into equity ahead of any taxpayer-funded bank bailout.  The rule, strongly backed by a handful of E.U. countries, concerns ECB President Mario Draghi, according to a recently surfaced letter.  As opposed to reducing uncertainty, he fears that the interplay between the rule and the stress tests could add to uncertainty by making it hard for banks that fail the stress test but remain solvent to raise capital on the private markets.

Investors still can’t conduct a side-by-side comparison of E.U. banks because of differing capital standards, and many banks are still undercapitalized.  By contrast, the U.S. recapitalized its banks in the immediate aftermath of the financial crisis. This is just further proof that financial integration is easier said than done in the context of a multi-state system.  

For more on this story, read MNI and Bloomberg BNA.  Additionally, this article in the Financial Times provides a superb background on the new rule requiring banks to convert subordinated debt into equity before receiving a taxpayer-funded bailout.