More European banks should have been wound down as a result of the eurozone sovereign debt crisis, rather than being propped up their governments, according to Andrea Enria, chairman of the European Banking Authority (EBA).
"I am convinced that too few banks in Europe have been wound down and disappeared from the market so far. It has been fewer than 40 institutes, in the United States by comparison there were about 500," he told German daily Frankfurter Allgemeine Zeitung.
Enria'a comments came in the context of ongoing efforts to make the eurozone's financial sector safe from any future financial meltdowns.
During the sovereign debt crisis, it was found that many financial institutions in the eurozone were far more vulnerable to economic shocks than they first appeared to be.
Therefore, the EBA was tasked by the European Central Bank with developing standards which would help policymakers in Frankfurt and Brussels spot risks in the banking sector of the eurozone.
The ECB is supposed to begin the supervision of the eurozone's financial institutions in 2014 and on the 21 October, the EBA published its policy recommendations to flag up the continent's dangerous banks.
Enria said that it was sensible to set out the stress scenarios to be used in the tests shortly before the exercise begins.
"It would be good to time the announcement shortly after the EU Commission releases its spring forecasts," Enria said.
He added that the tests should be based on the most current macroeconomic projections possible.
"As to the methodology, we want to make that clear earlier. We are already very far advanced."
Sovereign Bonds Remain a Problem
However, he pointed out that the treatment of losses on sovereign bonds remained a problem because they are considered risk-free under current banking rules.
"Government bonds that are in the trading book in banks' balance sheets and are declared as being up for sale should be marked to market value, even if that causes losses," he said.
While big banks are already attaching some risk to government bonds in their internal models, the question is whether the risk-weightings are appropriate, particularly as there are big variations in how individual banks treat the same bond, Enria said.
"That won't do," he said, adding that the EBA would push for consistent and conservative valuations in the stress tests.
"We don't want banks to throw out their own risk models, but we need consistency," he said.
Dealing With Bad Banks Quickly
Recently, Benoit Cœuré, who is a member of the ECB's executive board, gave a speech in Beijing where he said the eurozone had to find a way to close down distressed banks in the region quickly or face the consequences.
"The authorities can either choose between swiftly auditing and repairing the banking sector, which will help restoring credit flows, or they can allow forbearance, which will harm the long term prospects of our economy," according to Cœuré
"In one direction lies the Japanese experience, and in the other direction that of emerging East Asia," he said.
Cœuré referred to East Asia's financial crisis in 1997: policymakers in the East Asia's financial crisis had moved rapidly to reform their broken financial sectors. The Japanese, by contrast, did far too little and paid the price.
"Given the financial nature of the Asian crisis, this was a key element in resolving it. Non-viable financial institutions were closed, viable institutions recapitalised and strengthened, value-impaired assets dealt with and the corporate sector restructured, including through foreign investment.
"These measures were implemented decisively. They were associated with a painful adjustment process in the crisis countries but, at the same time, they made a swift recovery possible."
He hinted that Japan's fate of a lost decade could be Europe's if policymakers did not act decisively.
"Following the bursting of Japan's asset bubble, there was by and large no rapid write-down of non-performing assets. Due to the low profitability of banks, it was believed that an immediate write-off of bad loans would prevent compliance with capital requirements.
"The recognition of losses was postponed and, as a consequence, capital continued to be allocated to investments with limited positive impact on Japan's long-term growth potential, which some have called 'zombie lending'. Ultimately, this resulted in Japan's 'lost decade', namely an extended period of anaemic growth."