It’s an inflection point. This Sunday, the European Central Bank (ECB) is due to release the results of its Asset Quality Review (AQR) after having given the results to the 130 reviewed institutions earlier this week. As we have written about several times in prior weekly reviews, this report is a pivot point by which the market will get another signal of how serious Euro-area policy makers are about following the path to recovery that the US sketched out several years ago. By forcing banks to recognize bad assets on their balance sheets and to recapitalize through capital raising and restrictions on dividends, the banking system in the US right-sized more quickly and shortened the period of disruption to credit creation in the economy. Instead, the Eurozone has suffered from several years of private credit contraction – particularly damaging to the region because roughly 80% of capital provided to businesses comes through the bank channel (as opposed to capital markets). We can understand the hesitancy for European policy makers to have followed suit so quickly. When the US was delivering their banks, it was levering up its government to balance it out. At the time, Europe’s sovereign risk was under question itself and not in a place to support wide scale bank restructuring. But the picture has improved in these past few years.
The natural question is what is a “good” report? To us, a good report is not one that shows that all the banks passed just fine. Instead, seeing that stringent criteria was applied to provide a realistic picture to investors and the banks themselves of how much capital they will need is more favorable. It may seem odd, but we perceive a report that shows that a healthy amount of capital raising is needed as a “good” report. It would open the door for policy makers (fiscal and monetary) to use the information as support for bolder action on multiple fronts. A report that says that all is well would be perceived as having their heads in the sand.