Strong action by members of the European Union to establish a European Stabilization Mechanism to help countries in difficulty has helped calm markets, as has austerity plans announced by a number of countries, including Greece, Ireland, Spain, and Portugal. The European Central Bank (ECB) has also proved to be an anchor of stability throughout the crisis. Following much debate, the results of bank stress tests conducted on a large set of banks in the 27-member European Union will now be published on July 23. Successful tests should allay market concerns about the health of major European banks, and boost confidence in the Euro area.
These are all positive developments. But concerted action to sort out public finances across the Euro area, and a strategy for reinvigorating growth and creating jobs will be key to achieving a sustained recovery, the IMF said in its annual health check of the 16-member Euro area. Restoring growth is not just important for its own sake―it is also essential to lay to rest worries about public debt.
A well-functioning financial system will be crucial to strengthening the moderate and uneven recovery that is currently under way in the Euro area. But continued worries about public finances may impact the financial system adversely, the IMF warns in its report. In turn, problems in the financial system threaten the real economy. They make life especially difficult for the small and medium-sized enterprises, which depend on a sound banking system to continue to create jobs and deliver the majority of goods and services to households
To measure the underlying health of the banking system, authorities in the Euro area are subjecting major banks to ‘stress tests’. These tests simulate how well banks would perform under adverse economic and financial conditions. The European stress tests are overseen by national supervisors in the countries involved in the exercise, and coordinated by the Committee of European Bank Supervisors. They are aimed at testing the resilience of large banks to credit losses in the corporate and household sectors, and at assessing the effect of continued reliance on government support on large banks in the Euro area.
The broad coverage of institutions and risks should allow for a credible test. To maximize confidence building, the IMF report recommends full disclosure of the findings and effective follow up. Ideally, banks should be able to replenish any capital needs from private sources. But a backstop from official sources may be necessary. In that regard, the report notes, the recent extension by many Euro area countries of existing recapitalization and guarantee schemes is reassuring.
Resolving tensions in the banking system is also key to allow consumers, companies and others to benefit from the low policy rates of the ECB. The ECB has stepped up its non-standard operations to ensure sufficient liquidity and help ease tensions. These measures are entirely appropriate as a response to the difficult conditions prevailing in the markets. But over the medium term, banks should interact with each other rather than through the central bank to ensure the proper functioning of the financial system.
© International Monetary Fund
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