The stress test

To prevent a credit contraction in a recession, EU banks must be forced to hold enough capital to sustain lending, writes the Financial Times.

Financial Times

The International Monetary Fund expects writedowns by banks in the eurozone to reach $750bn in the next two years, plus $200bn more in the UK. They need fresh capital in similar amounts to achieve capital cushions common in the 1990s. …

One reason for Europe’s delayed implosion is that most of its financial intermediation is still done by banks, not a shadow banking system. Securitised lending is a small part of total credit. But since recession hit the real economy, European banks have been finding their loan books worth less than they thought.

Accounting rules also allow banks to avoid writing down losses on loans until they materialise. But that does not remove their incentive to deleverage, if they expect those losses to come eventually. Policymakers are therefore right to worry that credit is being withheld from the wider economy. To prevent a credit contraction in a recession, banks must be forced to hold enough capital to sustain lending.

Hence the need for capital adequacy audits or “stress tests”. In Europe’s integrated banking market, such tests … should be designed in common and applied consistently in different countries. A patchwork of national solutions inevitably distorts competition and ignores their negative effect on neighbouring countries.