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Last month's European bank test wasn't stringent enough

Michael Probst/AP/Michael Probst/AP

There's still time to undo the European bank test fiasco. Last month's exam encourages lenders to shrink their balance sheets by giving them until June, 2012 to meet the target. It would be far better for banks to be stuffed with capital now.

The test, which was blessed by last month's ill-fated European summit, had two problems. First, it wasn't stringent enough: the European Banking Authority concluded that Europe's lenders needed an additional €106-billion ($147.5-billion) when the International Monetary Fund thought about twice as much was needed. The test has done little to restore confidence in the blighted sector. Banks are still unable to issue long-term unsecured debt, and have been increasingly thrown back on short-term support from the European Central Bank.

Second, the test encouraged deleveraging by expressing the capital requirement as a ratio and giving lenders eight months to get there. Given depressed share prices, many banks are anxious to avoid issuing equity. Instead they are trying to boost capital ratios by shrinking their balance sheets. This will almost certainly have the unfortunate side-effect of further suffocating the European economy, which is already on the edge of recession.

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The best way to reverse the damage would be for a higher capital requirement to be agreed – and for it to be expressed as an absolute number rather than a ratio. The higher capital figure would give banks and investors confidence that the job was done. And if lenders were required to raise a specific amount of capital they would have little incentive to shrink their balance sheets too fast.

Most banks would probably be unable to find capital on their own. States would have to step in and partially nationalize them. If some governments can't afford to, they would have to be bailed out by the euro zone.

To sweeten the pill, the ECB could also make long-term funding by providing two or three-year loans rather than its current one-year maximum. Such a move would please banks as well as governments. And if the banks were properly capitalized as part of such a deal, the ECB might be ok about it too. For such a deal to fly, everybody would have to compromise. But it is better than having zombie banks haunting a zombie economy.

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