Europe’s Banks Aren’t Ready for the Next Crisis

(The Bloomberg View) -- A renewed bout of distress among Greek and Italian banks illustrates a deeper problem in Europe: The financial system’s overseers haven’t done nearly enough to prepare for the next crisis. They should redouble their efforts before the window of opportunity closes.

The European economy may be doing relatively well, but you wouldn’t know it to look at the tanking share prices of Greek and Italian banks. The underlying issues are idiosyncratic: In Greece, a string of poor quarterly results and the country’s exit from its international rescue program have raised concerns about how banks will fare without official support; in Italy, the ruling coalition’s impossible fiscal promises have undermined confidence in the government’s financial viability. But there’s one theme in common: Investors don’t believe that the banks’ balance sheets are as strong as they need to be.

Unfortunately, their doubts are well-founded. Lenders in Greece and Italy have among the region’s highest ratios of bad loans — 47.6 percent and 11.4 percent, respectively. Italian banks are also heavily exposed to their government, which has the euro area’s second-highest debt-to-GDP ratio (after Greece). Government bonds comprise 10 percent of the banks’ total assets, nearly three times the euro area average.

This is not how Europe’s banking union should work. When the European Central Bank took over responsibility for the region’s financial system in 2014, it was supposed to ensure that banks were strong enough to survive shocks without requiring public support. Granted, it has made some progress. Italy’s bad-loan ratio used to be even higher, and Greece’s banks have so far stuck to a timetable to pare theirs down. Yet the efforts have not been ambitious enough. Stress tests, for example, have been far from credible: A round in Greece earlier this year concluded that the country’s banks didn’t need any additional capital.

The market’s negative assessment demonstrates that the ECB (and specifically the next head of the Single Supervisory Mechanism) must do more. It should push banks harder to shed non-performing loans, and to reduce their exposure to the debts of their own governments. It should also require that they have enough loss-absorbing equity capital to survive a severe economic downturn and still have plenty left over. If they can encounter distress even in the current relatively benign environment, there’s no way they can act as a source of strength in a real crisis.

A proper cleanup will probably require the ECB or national regulators to shut some banks down. This is painful but necessary: Fragile banks do little for the economy. If they are systemically important, there may be a case for recapitalizing them with public funds — as long as private investors share some of the burden. If necessary, those funds should come from the European Stability Mechanism, the currency union’s rescue fund.

The latest bouts of financial turmoil offer a useful reminder that the next crisis might not be far away. Europe must finally get ready.

Editorials are written by the Bloomberg View editorial board.

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