EDITORIAL: Tests on European banks

The results of stress tests on major European banks conducted to ease fears about the stability of the continent's banking system have been released. More than 90 percent of the 91 tested banks passed, with only seven flunking due to capital inadequacy.

The tests have been beneficial because they revealed important information about the financial strength of these banks. But with critics saying the tests were not rigorous enough, it is not yet clear whether the results will calm investors worried about the soundness of the European financial system.

The safety of European banks depends on market views about the creditworthiness of the sovereign bonds of European countries they hold. The tests have made it clear that the financial health of European banks is ultimately determined by the fiscal sustainability of countries in the region.

Policymakers need to figure out a way to fix both their banking system and public finances through integrated efforts that don't undermine growth of the real economy. That will be a daunting challenge, like solving a complicated set of simultaneous equations.

The stress tests were carried out according to a unified formula developed by the Committee of European Banking Supervisors, which advises the European Commission. But they were actually administered by each country's banking regulators.

Even before the outcomes were announced, officials of various governments expressed optimism about the diagnosis of banks in their countries. Such remarks raised doubts about the credibility of the tests. Suspicions persist about deliberate underestimations of the risk of further declines in real estate prices in areas where financial bubbles have collapsed, such as southern Europe.

The assessments of the government bonds of European countries held by banks were not strict enough, either. Even the bonds issued by countries believed to be at risk of default, such as Greece, were regarded as posing no risk of loss to holders as long as they are held until maturity.

The European Union is firmly determined to never let any member country default on its debt. The EU has taken a series of steps, including the creation of a bailout fund to rescue countries like Greece jointly with the International Monetary Fund. In conducting the stress tests, the EU stuck to its position that there would be no sovereign defaults by its member countries.

On the other hand, European regulators have met expectations of market players to some extent by getting banks to disclose details of their government bond holdings--information they had held back.

The similar stress tests on U.S. banks carried out in spring last year were considered a success by some experts. But there is clearly a limit to the effectiveness of such tests on European banks because the crisis in Europe is more complex, with interwoven factors causing anxiety about the creditworthiness of both banks and governments.

The credit crisis in Europe could put a drag on global economic growth by, for instance, depressing stock markets around the world. U.S. Federal Reserve Board Chairman Ben Bernanke recently described the nation's economic outlook as "unusually uncertain." China's strong economy would suffer if its exports to Europe fall due to the crisis. It would be impossible for Japan to remain unaffected.

EU policymakers must take determined action to prevent the world economy from slipping back into recession. Acting on the results of the tests, they should take steps to accelerate efforts by banks to dispose of their bad assets through consolidation and recapitalization. They also have to improve information disclosure, which has often been criticized as inadequate.

In addition, European leaders need to strengthen confidence in sovereign debts and the euro by ensuring that countries that have bred and triggered the crisis, such as Greece and Spain, will make steady progress in fiscal rehabilitation and structural reforms of their economies.

--The Asahi Shimbun, July 27