Nicolas Véron

Banking Union Was Euro Crisis Turning Point: Two-Year Anniversary

This piece was just published by the Peterson Institute and Bruegel, on the second anniversary of the Euro area meeting that initiated Europe's banking union. 

Europe’s banking union, constituting a supranational pooling of most instruments of banking policy, was established two years ago, in the early hours of June 29, 2012. To a greater extent than was initially realized by most observers, this step marked a watershed in the European crisis by making it possible for the European Central Bank (ECB) to stabilize sovereign debt markets. The banking union will also profoundly reshape and realign Europe’s financial system and institutions, with consequences that will unfold gradually.

The summit declaration establishing Europe’s banking union made three points: the intent “to break the vicious circle between banks and sovereigns”; the integration of banking supervision within the ECB; and a suggestion that the European Stability Mechanism (ESM), the euro area’s common fund, would be allowed to recapitalize banks directly under certain conditions.

Developments in Spain soon encouraged cynicism about direct ESM recapitalization. Investors only started releasing the pressure on periphery sovereign spreads four weeks later, when Mario Draghi, the ECB’s president, pledged to do “whatever it takes” to defend the euro area’s integrity, a stance later formalized as the Outright Monetary Transactions (OMT) program of conditional sovereign bonds purchases.

But even though the definitive history of these crucial weeks of mid-2012 has yet to be written, and the ECB is bound to present its policy decisions as independent from the political process, it is doubtful that OMT would have been possible without the prior announcements on June 29.

In a recent speech, European Council President Herman Van Rompuy stated that “the Central Bank was only able to take this [OMT] decision because of the preliminary political decision, by the EU’s heads of state and government, to build a banking union.” In October 2012, Mr Draghi described OMT as a “bridge” that “must have a clear destination” and said the single supervisory mechanism was “a key step” in defining that destination. This follows a pattern of ECB actions coming after political breakthroughs: its Securities Markets Program came after the European Financial Stabilization Facility’s creation in May 2010, and the implementation of three-year Long-Term Refinancing Operations was undertaken after the Fiscal Compact in December 2011.

Subsequent developments have demonstrated how much the banking union was a game changer. Granted, the commitment about ESM direct recapitalization was gradually deprived of any substance. But the centralization of supervision at the ECB has been enshrined in remarkably strong EU legislation. The future bank resolution framework, with a European resolution agency to be created next year in Brussels, is an awkward compromise between national and European decision making and funding. But it strengthens the prospect that creditors will share a larger part of the future burden of restructuring failing banks than has been the case in Europe so far.

A new banking levy is a notable case of introduction of a quasi-fiscal resource at the European level, and a much sounder one than the headline-grabbing but ever-postponed financial transaction tax. Crucially, the ECB’s supervisory role is front-loaded with the ongoing comprehensive assessment of the bulk of the euro area’s banking system, which is likely to end (belatedly) the systemic fragility impairing credit in Europe for seven years. Beyond this transition, the ECB’s indifference toward protecting national banking champions, or forcing banks to buy specific countries’ sovereign debt, is expected to lead to stricter supervision and market discipline, cross-border financial integration, and less reliance on banks in the financial system.

Banking union is no panacea. The ECB could still be less than rigorous in its bank review this year, which would squander the opportunity to restore trust. Several countries face disquieting medium-term economic, social, and fiscal prospects. Perhaps the wildest card now that perceived sovereign credit risk has abated is that EU institutions remain in a state of flux. As the center gains increasing discretionary authority, new channels of democratic accountability must develop. The recent appointment process for the European Commission’s president represents a response to this need through the empowerment of the European Parliament. But this trend is exacerbating the tension with the United Kingdom, which has not yet adapted to what Chancellor of the Exchequer George Osborne memorably called the “remorseless logic” of political integration in response to the crisis.

Even so, the anniversary of Europe’s banking union is worth celebrating. Two years ago, and for lack of alternative options, Europe’s leaders avoided their usual muddling-through complacency to do something radical—and it worked. They may need to muster such stamina again. 

Europe's Half A Banking Union

This piece was co-authored with Adam Posen as the cover story of the June 2014 issue of Europe's World (reposted with permission - © Europe's World)

This spring, the EU institutions agreed a series of legislative texts that suggest bank closure decisions will be taken at the European level, not nationally. A Single Resolution Board will be established in Brussels as a new EU agency, and backed by a Single Bank Resolution Fund to be set up by separate treaty. These measures complement last year's legislation for pooling the supervision of most of the European Union's banking sector by the European Central Bank (ECB) in Frankfurt.

The link between European countries' creditworthiness and that of banks headquartered in them still exists for a number of reasons: the limitations imposed on the Resolution Fund, the absence of common deposit insurance, and the insistence by some countries that so-called "legacy" bad debts cannot be paid for by common financial resources. In any event, it's inevitable that some European taxpayers will again be finding themselves the unwilling victims of more banking failures, perhaps as soon as this autumn.

Skepticism about Europe's banking reforms should, however, end there. Decisions made so far on Europe's banking union are significant, substantial, and likely to become entrenched. As we argued in June 2009 in a paper published by the Peterson Institute and Bruegel, a system-wide process of bank triage, forced recapitalization where it was needed, and restructuring was the tried-and-tested way to resolve Europe's systemic banking crisis, and to succeed it had to be done at the European rather than national level.

If adequately executed, the ECB's asset quality review (AQR) of the euro area's largest banks will provide a credible, though sadly belated, triage of the kind we proposed back then, if accompanied by the requisite resulting capital injections and restructurings. The early credibility of the AQR can be seen in banks' widespread and substantial cutbacks in loan books, and the far fewer but still extant capital raising exercises, over the last few months to get their balance sheets ready.

The starting point of Europe's banking union was the euro area summit statement of mid-2012, when EU leaders committed to:

• "break the vicious circle between banks and sovereigns,"
• centralize banking supervision at the ECB,
• and use the recently-created European Stability Mechanism (ESM) for direct recapitalization of individual banks, including those that were then in the process of being restructured in Spain under EU oversight.

Until that statement, EU member states had defended their local control over banking policy as an unnegotiable attribute of national sovereignty. What can be described as "banking nationalism"—a continued reliance on national policy instruments to defend and promote national banking champions in an increasingly integrated European financial market—can be identified as a key reason why the financial crisis of 2007–08 had such a severe impact on Europe, despite having started in the United States. It also explains why, unlike in the United States, European policymakers were unwilling to resolve it and were unable to rapidly reestablish trust in their banking system.

Before the crisis, national authorities had encouraged "their" banks to grow so that they could become predators rather than prey in what most anticipated would be a wave of cross-border banking consolidation across Europe. This ambition came at the expense of prudence about systemic risk; between 2003 and 2008, the aggregate assets of Europe's banks grew by the equivalent of almost the entire European GDP. The act symbolizing this era was the takeover of the Dutch bank ABN Amro by a consortium of the UK-based Royal Bank of Scotland, the Belgium-based Fortis, and (after a follow-up transaction) Italy's Monte dei Paschi di Siena. All three took on too much risk and debt for their own good in the process. They should have been discouraged from doing so by their respective home-country supervisors, but were not. All three acquiring banks then became costly failures, requiring fiscal bailouts and disrupting of credit flows.

After the crisis erupted in the summer of 2007, banking nationalism again stood in the way of swift crisis management and resolution. It was a classic collective-action failure. Many national authorities knew there were weaknesses in "their" banks, but were unwilling to address them before neighboring countries did likewise, as this could put their own local champions at a competitive disadvantage and maybe lead to their takeover by outsiders. This compounded the usual harmful incentives for bank supervisors to engage in forbearance, i.e. holding off on closing or forcibly merging regulated banks in the hope that an economic recovery (or the end of the supervisor's term) would spare them from the need to do so.

For each national authority, the incentive was thus to pretend that the extent of problem loans was not only exaggerated (while actually allowing them to increase), but also that the worst problems were outside of their own territorial remit (while going soft on supervision at home). This became all too apparent in the inadequate stress tests whose results were announced in September 2009, July 2010, and July 2011. Banks like Dexia were given a clean bill of health, only to collapse a few months later. Self-defeating supervisory behavior is hardly unique to euro area bank supervisors, but the escalation of such reality denial in the face of market panic and bank-sovereign doom loops in 2010–11 was the result of banking nationalism.

Seen in this light, the banking union is a direct solution to the Maastricht treaty's incompleteness in the banking area. The 1992 EU treaty combined a commitment to a single financial market and a single currency with a nationalistically-motivated refusal to integrate bank supervision and resolution at the European level. It took Europe's leaders five years of deepening credit collapse and financial crisis and a dramatic rise in Spanish and Italian sovereign spreads, plus the brief denial of access to dollar funding experienced by French banks in the summer of 2011, to realize that this combination was proving terminal. In late June 2012, with the single currency's survival at stake and running out of options to prevent a break-up, they took the extraordinary but necessary step of effectively bidding farewell to banking nationalism.

Perhaps inevitably, a combination of policy successes and setbacks marked initial implementation of the banking union commitment. An early disappointment came in mid-September 2012, when the finance ministers of Finland, Germany, and the Netherlands issued a joint statement opposing any direct bank recapitalization by the new European Stability Mechanism to bridge "legacy" capital gaps, i.e. losses on investments made by banks before the banking union. The statement reversed the prior agreement by those same countries' at the European Union's June 2012 summit that the ESM would directly recapitalize Spanish banks, if only retroactively. That reversal understandably raised doubts about the northern euro members' commitment to the entire banking union project. However, thanks to the announcement by the ECB of its Outright Monetary Transaction (OMT) commitment, as well as the justified belief that although legacy losses were finite, banking union would be forever, investor sentiment shifted to a new equilibrium that discounted the likelihood of a euro area collapse.

The establishment of the Single Supervisory Mechanism (SSM), however, was pursued with speed and determination. By December 2012, all member states agreed on draft legislation that empowered the ECB as the bank licensing authority for the whole "banking union area", including the euro area but also including any non-euro EU country that might join the banking union voluntarily. In a concession to the uniquely powerful German local bank lobby, most smaller banks with balance sheets under €30 billion were exempted from direct supervision by the ECB. But that low threshold still leaves the vast majority of the banking union's banking assets, including almost all German Landesbanks and other mid-sized institutions, under the ECB's immediate authority. Furthermore, the ECB has room to expand its remit and retains ultimate licensing authority over all credit institutions. The ECB also gained enforceable access to information from supervised banks, and the legislation makes it practically impossible for individual national authorities to obstruct ECB supervisory processes. Despite the delays resulting from the subsequent negotiation with the European Parliament, and various procedural roadblocks by Berlin during Germany's pre-election period, the SSM Regulation of October 2013 stands out as a swift and comprehensive pooling of sovereignty with few equivalents in the whole history of the European Union.

More recently, the European Union adopted a Bank Recovery and Resolution Directive together with the Single Resolution Mechanism, in principle paving the way towards a future in which the resolution of insolvent institutions would be conducted at European level and would minimize recourse to public funding. Unlike the SSM, the Single Resolution Board will be single in name only, as the legislation that sets it up foresees a significant degree of lingering autonomy for national resolution authorities.

Other progress has been made towards a banking union, though not all changes were equally comprehensive. The adoption of the Capital Requirements Regulation in June 2013 was a significant step towards having a "single rulebook" that the ECB could enforce uniformly across the banking union area, even though it regrettably deviated from the Basel III accord on several important points. Simultaneously, countries including France and Germany adopted idiosyncratic national laws on the separation of activities within banking groups, which conflicted with their stated commitment to the banking union. The most worrying gap remaining is that the unification of deposit insurance within the euro or banking union area has not even been broached by political leaders. This is understandable in the absence of a fiscal union that could credibly back it, but its absence underscores the dangers of incompleteness, a good example having been the huge movements of savings across borders after Ireland's unilateral extension of deposit insurance in 2008.

With supervision now meaningfully integrated within the ECB, centralized resolution on the right path even though not yet there, and common deposit insurance sadly off-limits, it is fair to label the current legislative arrangements a "half a banking union." It is much more than a small step on the journey towards eliminating the vicious circle between banks and sovereigns, but it's still incomplete. As always in European institutional development, the question is whether a half-measure of integration is helpful or is too slow and even dangerously unstable. Our view is that in the case of half a banking union, this is sufficient progress to be meaningful and of a stabilizing nature. As we argued in 2009, to end the European banking crisis required the strict testing of bank solvency by a European-level authority using a unified and transparent standard. The half a banking union meets these criteria.

Crucially, the key transition step was put into motion by Article 33(4) of the SSM Regulation, which mandates the ECB "to carry out a comprehensive assessment, including a balance-sheet assessment, of the credit institutions" that it would start directly supervising in November 2014. The importance of this process, now widely referred to as the asset quality review (AQR), has become ever more obvious during the course of 2013. It amounts to a massive front-loading of the ECB's supervisory effort by a near-term deadline that is now approaching. This requirement creates large operational as well as political challenges, but to its credit the ECB is taking them on. One can hardly imagine the ECB granting or confirming a banking license to a bank that it wouldn't consider insolvent—and the many past failures of national supervisors imply that the ECB could not base its initial supervisory assessment only on their respective opinions. Most importantly of all, the AQR holds the promise of putting an end to the systemic banking fragility that has affected Europe since mid-2007.

It is now possible to be confident that the AQR will be more robust and credible than the previous European stress tests. The ECB will have direct access to bank information that was unavailable to the Committee of European Banking Supervisors (CEBS) in 2009 and 2010, and to its successor the European Banking Authority (EBA) in 2011. As the future supervisor, it will be able to demand much more cooperation from both banks and national authorities, and it has the legal means to enforce its information requests. It has a much larger staff than the CEBS or EBA had, and in addition can rely on armies of consultants and auditors. But given that the previous European stress tests ended in policy failure, just this comparative statement of capabilities may not be enough to guarantee that the AQR will be certain of success.

Nor can the success or failure of the AQR be demonstrated simply by either zero forced recapitalizations, which is likely to mean too soft an approach, or by some pre-set target number of banks being compelled to fail, which would be likely to indicate arbitrary political decisions rather than by supervisory assessment. In essence, the AQR should be deemed successful if three criteria are met:

• On the micro-prudential level, it will succeed if there is no equivalent case to Dexia in 2011—meaning that insolvent cross-border banks get identified and resolved rather than having their problems put aside and allowed to accumulate;
• On the systemic stability level, it will succeed if credit growth to normal nonfinancial borrowers turns positive again after the AQR results and any recapitalizations;
• On the market level, it will succeed if there is greater differentiation of prices among bank equity and debt within any given national economy, and banks deemed sound are not excessively punished for their country of headquarters—i.e., a narrowing of spreads.

Not all of this will be revealed immediately at the time of announcement of the AQR results, expected in October, but we expect there will be many indications within a short period of time thereafter.

The ECB's approach appears, reasonably, to be to incentivize banks to act ahead of this deadline, to write down any dubious assets, and to recapitalize proactively to the extent needed, as Italy's UniCredit and Intesa Sanpaolo and Germany's Deutsche Bank have announced. But pre-emptive capital-raising is unlikely to be feasible for the weaker banks, which may fail to convince investors to buy newly issued capital instruments, and may also be unable to sell distressed assets at prices high enough to bridge their capital gap. Problem banks of this sort will need restructuring or resolution by national public authorities, as ESM direct recapitalization is unavailable for "legacy" situations, and the Single Resolution Board won't yet exist when the AQR results are announced.

For the AQR to succeed, the ECB must not flinch at naming problem banks, and the relevant member states must address them in a manner consistent with their policy commitments, including the new state aid rules issued last year by the European Commission that restrict the potential for overt or covert bank bailouts. The fact that lending has been falling even as the euro's growth prospects have been improving and government interest rates have declined is evidence that the banks subject to the AQR have been taking this threat as credible and are raising their ratio of capital to loans. And the self-separation of those banks that can raise sufficient capital from those that cannot is further evidence, as well as progress on our third criterion.

Against this yardstick, our expectation is that the AQR will be broadly, if perhaps not entirely, successful. There could still be a failure of nerve by the ECB to see this through, or an unwillingness of a national resolution authority to do its job, but we believe this is unlikely to be on a large enough scale to compromise the whole exercise. Such a failure would have major negative consequences for the ECB, the euro area and the European Union as a whole, which would become apparent in markets almost immediately. The point of public pre-commitment is to make the costs of reneging so high that carrying out an obviously unpleasant duty nevertheless becomes a matter of self-interest. Government talk is often cheap (witness the previous failed European bank stress tests), but our assessment is that European policymakers, including the ECB, have now made a credible commitment. They have burnt their bridges and cannot retreat.

Assuming a successful AQR, the European half a banking union will become a reality, offering a reasonably clean and well-capitalized starting point for the vast majority of the banking union area's bank assets and all of its large credit institutions. Barring large external shocks to European financial stability, we expect this to have a more transformative impact on Europe's financial and economic structures than many observers seem to realize. This impact should become evident along a number of dimensions:

• Credit crunch resolution: A successful and complete AQR would trigger the return of trust in Europe's banks and an end to balance sheet contraction in those banks. This will improve retail credit conditions, particularly in the European periphery, thus reducing a major drag on economic growth and employment. A reliable signal of a return to normality would be growth in bank lending to small and medium-sized enterprises, with reduced spreads between lenders from different member states. On the policy side, this would allow an exit from the Eurosystem's extraordinary liquidity provision program to banks, known as fixed-rate full allotment, which has been in place since October 2008.
• Stricter supervision: Unhampered by banking nationalism, the ECB is likely to be a more demanding and less forbearing supervisor than the national authorities it will supersede. This will apply to supervisory practice, but we expect it will also improve regulation. Compared with national authorities from the euro area in the recent past, the ECB will not resist as much the strengthening of regulatory standards at the Basel Committee and in EU rulemaking processes, even though it may still champion advantages for European banks in international discussions.
• Fewer taxpayer-funded bailouts: As banking nationalism was a major driver of the EU preference for public bailouts during the first five years of financial crisis, the shift of supervisory authority to the ECB lends credibility to the proclaimed objective of relying more on "bail-in" and financial burden-sharing by creditors in future bank restructurings—even though systemic stability considerations would still justify a recourse to public financing in severe crisis scenarios. This in turn would further weaken the vicious circle between banks and sovereigns, a significant part of which is the anticipation of nationally-funded bank rescues.
• More cross-border financial integration within the banking union area: The ECB will have no incentive to discourage cross-border entry and acquisitions, as national authorities have done time and again in spite of formal commitments to the EU single market. In turn, the gradual emergence of truly pan-European banking groups will create a powerful interest in favour of the gradual elimination of countless cross-border competitive distortions and onerous national "gold-plating" of the EU single rulebook. In this new political economy, Europe's banking market may become more open to entry by non-European-headquartered banks, including into retail market segments, or at least more open to pressure on this front.
• The reduced dominance of banking in European finance: So far, banks have remained uniquely dominant in Europe's financial system when compared to other developed economies. One reason is the protection they have enjoyed from public authorities against potential competition from alternative credit channels, again motivated consciously or not by banking nationalism. The ECB has indicated it would take a much more sanguine view of the growth of market-based finance and nonbank financial intermediaries. Together with the previous point, this might contribute to a more diverse European financial ecosystem that could prove both more supportive of growth and employment, and more resilient in the face of systemic risk.
• A lower home bias in sovereign debt portfolios: The large holdings of home-country sovereign debt by a number of banks, particularly in periphery countries, have powerfully contributed to the euro area's bank-sovereign vicious circle. A large part of these holdings result from so-called moral suasion, or nonpublic arm-twisting, by national authorities on the banks they supervise to help finance "their" national government. The ECB is unlikely to have any interest in exerting this.
• A new balance in external representation: The ECB and other European-level agencies such as European Securities and Markets Authority and the Single Resolution Board can be expected to gradually gain prominence, in comparison to national authorities in banking union area countries, in international bodies such as the Financial Stability Board, the Basel Committee and the International Organization of Securities Commissions.

Many things could still go wrong for European financial stability. The ECB could become too prescriptive on the corporate governance and business models of supervised banks, leading to a damaging erosion of diversity in banking structures within the banking union area. Political confrontation between European and national authorities over resolution of a given bank could prove damaging to the sustainability of the whole framework, at least in the early stages. Conflicts of jurisdiction may appear. The divide between the banking union area and the rest of the European Union could prove damaging to the single market, and if (as is likely) some noneuro countries join the banking union, competitive distortions between these and the euro area could arise. The exclusion of smaller banks and nonbanks from direct supervision at European level could lead to harmful regulatory arbitrage. The reduced ability of member states to exert moral suasion over local banks will create political resistance to what reduces credit availability in dependent regions and sectors. But even with all these risks in mind, we are convinced that in terms of financial stability and beyond, the half a banking union that has been undertaken will be transformative and positive for the European Union.

The ECB’s Bank Review: Kill the Zombies and Heal the Wounded

This blog post co-authored with Ajai Chopra was just published by the Peterson Institute and Bruegel. 

The European Central Bank’s comprehensive assessment of euro area banks has had an encouraging start. But complacency could still lead to another failed attempt to fix Europe’s banks, with severe consequences.

The ECB’s bank review looks like it will be more credible than the discredited EU-wide stress tests in 2010 and 2011. The ECB has its own reputation at stake, and has strong incentives to ensure that legacy problems are addressed before taking over from captured national authorities as the banks’ direct supervisor.

Unlike earlier exercises, the assessment of banks’ soundness starts with an Asset Quality Review (AQR), which is an examination of the asset side of bank balance sheets as of the end of 2013. The exercise involves 128 banks and covers the vast majority of the euro area’s banking assets. Asset valuation adjustments following the AQR will feed into forward-looking stress tests factoring in adverse economic assumptions, on the basis of which the ECB will assess the banks’ capital shortfalls. Previously, banks and supervisors in different countries adopted different and often lax approaches to the valuation of assets, collateral and guarantees and to the classification of impaired loans. By using an army of auditors to assess non-performing exposures, collateral, and provisions, the AQR should enable the ECB to assemble and disseminate consistent information across banks and countries. In an encouraging sign, this exercise appears to have already spurred many banks to increase loan-loss provisions and capital.

But the most critical part of the exercise still lies ahead, and could be harder than many investors and policymakers expect. The technical and logistical challenges alone are daunting, especially because the ECB is still building its staff and skills.

In addition, national supervisors will still play a critical role. They can use their position on the new Supervisory Board within the ECB to promote the narrow interests of banks and authorities in their countries. For example, the published benign assumptions for the adverse scenario in the stress tests — such as only a mild decline in property prices in Ireland, or no allowance for deflation in countries such as Spain — were likely promoted by national authorities. Weak stress assumptions make it more difficult for the ECB reestablish trust that banks are sound.

Another danger is that the results may not be disseminated quickly enough or in a transparent manner. The AQR is to be completed at the end of July, followed by the stress test, but the ECB does not intend any disclosures until late October, and may delay necessary supervisory actions beyond this date. But securities laws may require earlier disclosure of any discrepancy between previous and new estimates of capital, for example.

In the absence of a common euro area backstop to protect market confidence, there is a further danger of regulatory forbearance in the form of understated capital needs. Many also fear that the ECB might single out problems in banks from smaller and less powerful countries in an attempt to make the exercise look credible, while papering over cracks in more powerful countries. Even in small countries, the ECB may hesitate to declare a bank insolvent if the national government appears unable to deal with it. Capital requirements may also be understated for technical reasons, because of the primary reliance on complex risk-weighted ratios that can be manipulated and because of the ECB’s own lack of deep accounting and valuation experience.

Closing unviable banks and recapitalizing and restructuring viable ones are inherently painful and politically charged steps. Structures to manage failed banks and assets remain inadequate in Europe. In addition, domestic bank governance structures (e.g., the role of foundations in Italy, regional cooperatives that control Crédit Agricole in France, or public shareholders in Germany) could impede the ability to raise new capital. Before the EU’s Bank Recovery and Resolution Directive takes full effect in 2016, the policy stance toward forcing losses on (or bailing in) unsecured bank creditors if there is a capital shortfall remains unclear.

Overcoming these handicaps is feasible but difficult. To maximize prospects for success, the ECB must first be prepared to mercilessly identify the weaker banks, including “zombie” banks that pretend to be sound, abetted by complicit national authorities. The AQR and stress tests should separate banks into three groups: those that are sound without additional corrective measures; those that can be made viable with corrective measures; and those that are not viable and should be closed in an orderly manner, which could include a merger with other strong banks. Kill the zombie banks, and heal the ones that are only wounded. Danièle Nouy, the euro area’s new chief supervisor, has acknowledged that some banks must disappear. Delivering on this will be critical.

This policy does not imply a target big number for the aggregate capital gap for the euro area. The critical success factors will be rigor and evenhandedness in identifying capital shortfalls in core countries as well as the periphery, and not shying away from declaring banks to be insolvent. Encouragingly, independent estimates of the aggregate capital shortfall such as those by Viral Acharya and Sascha Steffen suggest that even if public backstops are needed, their magnitude will not likely damage sovereign debt sustainability.

Transparency is essential. As Karl Whelan has pointed out, the standards must be higher than the cursory disclosure of AQR results by Irish banks in December 2013. Investors will want to know how supervisors deal with losses denied by banks claiming differences over asset classification or collateral valuation. Plans should be made to reduce the danger of chaotic dissemination of AQR results between July and October, emphasizing disclosure to provide uniformity and reduce unwarranted market turbulence. Although the stress test’s capital thresholds are defined in terms of risk-weighted assets, the disclosures should also include simple leverage ratios to provide a more complete judgment of whether banks are adequately capitalized.

Finally, member states need to adopt a rigorous approach to rectifying capital shortfalls while minimizing cost to taxpayers. Orderly resolution of insolvent banks should include writing down not only shareholders' equity but also hybrid instruments and subordinated debt. All member states that lack laws to do so should urgently enact them. Unsecured senior bonds should be “bailed in” to reduce the cost of resolving zombie banks. The corresponding requirements of the Bank Recovery and Resolution Directive do not come into full effect until 2016 and it is too late to amend EU legislation in time for the AQR results. Under these circumstances, a political agreement to adopt a common approach that imposes losses on unsecured senior creditors of zombie banks would avoid damaging divergence from one member state to another.

Shareholders of wounded but viable banks needing increased capital buffers should not be rewarded until satisfactory capital levels are attained. In addition, banks unable to raise sufficient private capital should come under state aid rules, making conversion of junior debt to equity a condition for public assistance. In sum, restoring confidence and clarity and minimizing cost to taxpayers should trump protections for subordinated and senior bank debt.

Closing dysfunctional zombie banks and restoring wounded ones to health will not be enough to pull the euro area out of its economic and political funk. But the hard work of recognizing bad loans and recapitalizing and restructuring banks will reduce the current drag on growth from banks that squeeze credit even from promising firms, and will contribute to economic expansion and employment. Europe’s policymakers need nerve and clear-sightedness for this opportunity not to be wasted.