Falling Short of Expectations? Stress-Testing the European Banking System

Abstract

The eurozone is mired in a recession. In 2013, the GDP of all 17 eurozone countries fell by 0.5% and the outlook for 2014 shows considerable risks across the region. To stabilize the common currency area and its (partly insolvent) financial system, a eurozone banking union is being established. An important part of the banking union is the Single Supervisory Mechanism (SSM), which will transfer the oversight of Europe’s largest banks to the European Central Bank (ECB). Before the ECB takes over this responsibility, it plans to conduct an Asset Quality Review (AQR) in 2014, which will identify the capital shortfalls of these banks. A comprehensive and decisive AQR will most likely reveal a substantial lack of capital in many peripheral and core European banks. This study provides estimates of the capital shortfalls of banks that will be stress-tested under the AQR using publicly available data and a series of shortfall measures. We document which banks will most likely need capital, where a public back-stop is likely needed, and, as many countries are already highly leveraged, where a EU-wide backstop might be necessary.

Keywords: AQR, stress tests, banking union, bail-out

JEL Classification: G01, G21, G28, G14, G15, F3