Will euro banks be saved before meltdown?

A protester uses a burning 10 euro banknote to light up fake euro banknotes during an anti-austerity protest in front of Greeces" central bank in Athens in September Image copyright AP
Image caption Will credible stress tests of European banks actually be run?

My colleague Rory Cellan-Jones will I am sure write a proper appreciation of Steve Jobs.

All I would say is that he was one of the towering industrialists of our age - and I think "industrialist" is the right word, even if none of his employees ever handled a monkey wrench.

What I am less clear about is whether he an Edison or a Ford - someone who invented vast numbers of different devices we now take for granted or who took a single thing (an IT "thing") and then revolutionised its design, sale and manufacture. He was probably a bit of both.

Anyway, of his generation, only Gates gives Jobs a run for his money as a creative business leader who changed how we live and work.

When you look at the way he helped both to create Apple and then in later years rescued Apple, when you consider how he launched products like the iPhone and iPad whose sales and profit margins defied the worst economic conditions since the 1930s, it is quite hard not to feel admiration.

I doubt many would feel the same emotion towards the politicians and regulators engaged in trying to prevent a meltdown in the eurozone.

Creeping progress

Now, as the FT reports this morning, the European Banking Authority (EBA) - the top regulatory body for Europe's banks - is debating how and whether to subject European banks to a new round of health tests or stress tests.

The penny has dropped that the last stress tests, whose results were published as recently as 15 July, were not credible - for the reason that was conspicuous at the time, which is that eurozone governments would not allow European regulators to build into the assessment of the strength of banks the possibility that any eurozone government may not be able to repay their debts.

So if there are to be new stress tests - and in practice the EBA will have to agree with eurozone governments before such tests take place - they will for the first time assess the losses that banks would incur in both their "banking" and "trading" books from a writedown of the debts of nations with huge deficits or debts, such as Greece, Italy, Spain, Portugal and so on.

Image copyright Reuters
Image caption Will UK's banks be forced to raise additional capital?

You can see this as creeping progress towards putting adequate shock absorbers into the eurozone's financial system.

If the fundamental disease is that individual eurozone countries have borrowed too much or are still borrowing too much, then the transmission mechanism making whole economies sick is the fear that banks possess too little capital to absorb losses that may arise if these country fail to repay all they owe.

So a serious test of their health would not only measure how much banks have lent to the likes of Italy, Greece and so on, which did happen in the last tests, but would also apply the current low market prices to banks' holdings of these loans (or sovereign bonds, in the jargon).

The application of market prices (or "marks") in this way would generate notional losses for banks, and it would then be possible to assess whether individual banks have enough capital to withstand the damage that could arise if the worst happened and a whole series of eurozone countries were to default.

Now it is one thing for the European Banking Authority to acknowledge the inescapable truth that confidence in Europe's banks will not be restored unless and until they have enough capital to protect themselves against this Armageddon scenario. It is quite another for eurozone government's to give their approval for such tests.

Because even if it is, in effect, only a war game, up to now eurozone governments have put a total prohibition on any official acknowledgement that there could be a substantial default by any eurozone country (the current Greek rescue plan does include an implicit 21% reduction in its debt burden - but that is at least 30 percentage points below what the market sees as the necessary writedown).

Fresh burden?

So here's the big question. Will credible stress tests actually be run and will European governments make sure that sufficient additional capital is injected into European banks?

Well, those close to the EBA caution me that the important decisions have not yet been taken.

They say three things.

First, that the most serious impediment to sanitizing the European financial system is the intransigence of the French government.

France's banks are perceived to be weak by investors and creditors. But France's big banks and French ministers say the market is wrong. Which is why the French government is proving most resistant to the idea of credible stress tests and an ambitious plan to inject perhaps €200bn of additional capital into eurozone banks.

Second, my sources are convinced that Europe's banks will be adequately recapitalised. But what they cannot say is whether this will happen in a sensible orderly way, or whether it will only happen five seconds before midnight, when markets are melting down.

Third, officials and regulators tell me that of the €200bn that may have to be injected into banks, some will come from commercial investors, some from national governments and some from Europe's bailout found, the European Financial Stability Facility.

Or to put it another way, there won't be an American-style TARP rescue.

Instead there will be a slightly messier process, in which there is central determination - by the EBA, in collaboration with national regulators - of how much individual banks need, and then individual countries will decide how the money can and should be injected into their respective banks.

Is there a chance that the UK's banks will be forced to raise additional capital, since the reach of the EBA is the whole of Europe, not just the eurozone? Well yes, there is a chance, but not a huge one.

But as it happens, none of our banks have massive exposures to the sovereign debts of weaker eurozone countries. Barclays for example has quite large retail loans in Spain, but relative small loans to the Spanish government. Lloyds and RBS have notoriously huge loans to Irish property businesses and homeowners, but not to the Irish state.

So the probability is that the creation of a proper cordon sanitaire around Europe's banks won't involve fresh burdens on the shareholders of Britain's banks or on British taxpayers.

Update 0940: The EBA has this morning said that its review of how much capital banks need won't involve new stress tests - which may be seen as a good thing, since wholly new stress tests would take time that the eurozone may not have.

Instead it will look at the data it gathered in the spring to determine which banks need additional capital.

The important point is that the EBA already knows which banks have greatest exposure to eurozone governments struggling to repay what they owe. So whether this exercise is seen as new stress tests or a reworking of the original stress tests is a largely academic point.