* Political resolve behind euro zone banking union falters
* Germany reluctant to bankroll clean up of banks
* Health checks could be last chance to confront bank
By John O'Donnell and Eva Taylor
BRUSSELS/FRANKFURT, Sept 27 The European Central
Bank's (ECB) plan to test the health of the euro zone's largest
lenders without the means to plug any holes it uncovers risks
foiling what some see as the bloc's final chance to put its
financial crisis behind it.
Unlike in the United States, where rapid infusions of
capital put its banks quickly back on track, Europe's financial
system remains frozen, with lenders in countries such as Greece,
Spain and Italy hurt by weak demand and soured loans.
To break the "doom loop" between indebted European countries
and their banks and reassure investors that stressed euro zone
lenders would be dealt with on a regional level, a banking
union, with the ECB as supervisor, is viewed as crucial.
"The U.S. turned the leaf on its banking crisis in 2009,"
said Francesco Papadia, former head of the ECB's financial
market operations, who helped guide the central bank's
management of the financial crisis.
"Now the euro area has a great opportunity, probably the
last one, to achieve this."
But the political will to forge full banking union has waned
as the heat of the crisis has passed, and German reluctance to
back a central fund that would potentially come to the rescue of
any troubled euro zone bank means that the ECB is preparing to
take on its role from late next year in a dangerous vacuum.
The ECB, both for its own reputation and the future of the
bloc, is under pressure to ensure that banks undergo a thorough
health check that will force them to recognise hidden losses.
But without a pan-euro-zone bailout fund, such tests could
highlight problems without a convincing solution, potentially
undermining the banking union project before it has fully taken
"To really solve the asset quality concerns, you need to
have a backstop. If you find a gap, you need to be confident you
can fix it," said Ronny Rehn, analyst at Keefe, Bruyette & Woods
(KBW) in London.
"If you don't have this, then we might have to lie to
ourselves again and say there is no problem because we couldn't
afford to fund the problem."
CONFIDENCE OR COMPROMISE
The ECB wants to check the health of big banks, under a
so-called Asset Quality Review (AQR), before taking over their
supervision. This will also help shape wider testing of banks
outside the euro zone, overseen by the European Banking
In Frankfurt, home of the ECB, there is growing resignation
that a pan-euro-zone backstop is unlikely and that countries may
be left to prop up their banks alone, as they were when the
financial crisis struck.
"We'll have to have national backstops in place," ECB
President Mario Draghi told the European Parliament earlier this
week. "If it (single resolution scheme) is not there in place,
it will be up to the national authorities ... which is
suboptimal, of course."
Such a compromise exasperates bankers, who want confidence
restored to the sector so their cost of funding drops.
"The ECB, EBA and EU are all saying that the AQR and stress
tests will be stringent," said a credit banker at a large
London-based investment bank. "It's easy for those to say that;
they don't have to come up with the money.
"It's the government I want to hear it from. I want to hear
from the government what happens if banks fail."
With confidence in European banks still low, the sector is
valued at a significant discount to U.S. peers, trading at
around par with the book value of its tangible assets compared
with around 1.7 times for the United States, according to an
analysis by KBW.
Europe's top 42 banks are already about 70 billion euros
short of meeting new international capital norms, even before
taking into account that they have often set aside too little to
cover unpaid loans or an economic slump.
"We see a problem primarily in Spain and Italy, because
that's where you have a housing market that's still in
freefall," said Jon Peace, an analyst with Nomura. "The small
banks have bigger problems than the large ones."
OUT ON A LIMB
Germany, the euro zone's strongest economy, which has
shouldered much of the burden for country bailouts, does not
want a scheme that leaves it on the hook. That aversion is
unlikely to change, whatever the outcome of current government
Berlin has suggested that a bank resolution agency should
only have power over the euro zone's largest lenders. That would
reduce any potential bill to be shared by the 17 euro zone
countries, but such a deal could mean that small risky banks, at
the heart of the current crisis, slip through the net.
The absence of a financial backstop to help banks once their
problems are laid bare may prompt the ECB to delay the tests of
banks altogether, a move that could postpone supervision and
damage the euro zone's image internationally.
The situation would be even worse if haggling between EU
governments delays agreement - now pencilled in for December -
on the 'resolution' framework to cope with laggard banks.
That would have a knock-on effect on talks to finalise the
regime with the European Parliament, potentially leaving the ECB
out on a limb when it takes on supervision, as now planned,
towards the end of next year.
"We will not start before governments have agreed on a
backstop - emergency funding for capital holes - which we might
find in the balance sheets," Yves Mersch, the member of the
ECB's executive board in charge of supervision, said on Monday,
referring to the bank balance sheet checks.
"This has nothing to do with sitting something out, but with
responsibility," he said. "This assessment could throw us back
into crisis, without clarifying the financing beforehand."
Putting off the day of reckoning could make the months ahead
easier but would likely come at a heavy cost for the ECB, which
has already lent the banks over a trillion euros in cheap
funding, mostly now repaid, and is expected to open the taps
again, possibly by the end of this year.
Most agree there cannot be a repeat of the two earlier
stress tests, widely considered flops for a series of blunders,
including giving Irish banks a clean bill of health months
before their problems pushed the country into an international
Ex-ECB man Papadia warned of the consequences should "the
ECB get scared" and soften its assessment of banks.
"The risk of this is that you would continue with the
opacity ... where people suspect there are big problems but
nobody knows where and how big they are," he said.
"The trust in the ECB would be affected, and, ultimately,
there would be consequences even for the currency."