European Central Bank Vows Thorough Review of Banks at Risk

Mario Draghi, president of the European Central Bank, said the review, which will begin in November and take a year, would be “an important step forward for Europe and for the future of the euro area economy.”

European bank stocks fell sharply Wednesday as investors apparently concluded that the review would be tougher than they expected, covering a greater range of assets. The Euro Stoxx banks index closed down 2.8 percent.

The deep dive into bank books is part of a larger attempt to unify Europe’s fragmented banking system under the supervision of the European Central Bank, so that lenders in the single currency zone play by the same rules and meet the same standards.

But the European Central Bank, with its credibility at stake, must show that it can succeed in eliminating doubts about European banks where other national and European authorities have failed. And it remains unclear who will pay to recapitalize weak banks or how terminally ill banks will be shut down without unleashing market turmoil.

“It’s a once-in-a-lifetime opportunity for the European Central Bank,” said Harald Benink, a professor of banking and finance at Tilburg University in the Netherlands. “They have a clear incentive to be tough.”

Mr. Draghi said in an interview with Bloomberg Television that the European Central Bank would not hesitate to fail banks in a planned test of their ability to withstand shocks.

“Banks do need to fail,” he said. “The test is credible because the ultimate purpose of it is to restore or strengthen private-sector confidence in the soundness of the banks.

“Ultimately that’s the objective,” Mr. Draghi added, “to have private-sector money to be put into the banking industry.”

The review of about 130 large lenders is intended to address one of the underlying problems in the euro zone economy by forcing weak banks to deal with problems such as bad loans or insufficient capital. Credit remains tight in much of Europe, in part because many banks are burdened with bad loans or because they lack confidence from investors and are unable to raise money on capital markets. Without credit a vibrant recovery is almost impossible.

The European Central Bank assessment is also a prelude to a significant expansion of the bank’s powers, which are already vast. In November, immediately after finishing the review, the European Central Bank will become the bank supervisor for the euro zone, responsible for policing the banking system and guaranteeing its stability.

There have been questions about what will happen if the European Central Bank finds banks with grave problems. No one really knows to what extent some banks in Italy, Spain, Germany and other countries may be covering up losses from bad mortgages, business loans or other investments. Estimates of potential hidden losses run into the hundreds of billions of euros.

“There is fundamental disagreement at the highest European level who is going to absorb losses and who is going to pay to resolve problems,” Mr. Benink said. “If it is not clear who is going to pay these backstops, you cannot have a credible review.”

Ignazio Angeloni, an European Central Bank official overseeing the review, expressed confidence that political leaders will resolve those issues by the time the assessment is finished. “All of those elements are in the making, and they will fall into place,” he said at a news conference Wednesday.

Unlike the United States, Europe has never really forced banks to confront their problems in a way that rebuilt trust among investors. That was partly because national bank supervisors were overly protective of their own banks. In theory, the European Central Bank would be more willing to put pressure on financial institutions. There are already indications that the threat of European Central Bank scrutiny has ignited a fire under banks and national supervisors.

“We expect that this assessment will strengthen private-sector confidence in the soundness of euro area banks and in the quality of their balance sheets,” Mr. Draghi said in a statement.