The eurozone is finally set to return to growth next year, but the single currency bloc may not have put its crisis behind it as efforts to shore up its banks could boomerang.
After beating back market panic that the eurozone was set to break up, eurozone nations moved last year and this year to put their finances on a stable footing and strengthen the banking sector.
A new pact puts their finances under stricter control, with an obligation to cut the high debt levels seen as one of the reasons behind the crisis.
Eurozone leaders also moved to create a banking union, to reinforce lenders and reduce the likelihood wobbly banks would force countries into bailouts. However the introduction of the banking union next year risks doing the opposite as lenders are given a thorough check-up but individual eurozone countries are left on the hook for the costs of treatment.
In the hot seat will be the European Central Bank (ECB), which is conducting the in-depth reviews of the top 130 or so eurozone banks before taking over as their supervisor at the end of next year.
Lax supervision by national regulators has long been a concern of the market, and the ECB could well find that numerous banks are undercapitalized or even insolvent.
Top euro area banks are to generate twice as many loan losses on average in the years to come than their non-euro counterparts in places like Britain and Switzerland, according to a recent study by the research arm of Moody’s ratings agency.
As each country will have to pick up the bill separately, the ECB may find itself come under intense pressure from member states to avoid sparking a banking crisis the likes of which have already forced Ireland, Spain and Cyprus to seek bailouts.
“The tension can be expected to generate more market volatility in Europe in 2014 than was seen in 2013,” Nicolas Veron of the Bruegel Institute think tank said in a recent comment.
The ECB, which has been credited with rescuing the euro by calming markets, could ironically find itself unleashing the next panic if it conducts a rigorous review of banks that is widely seen as necessary for a sustainable recovery of the eurozone.
“The ECB will be in no position to demand that banks raise capital if there is no backstop,” Wolfgang Muenchau said in a recent Financial Times commentary.
Eventually there will be a common 55 billion euro (US$75 billion) fund to help close down banks, but following opposition from Germany, the eurozone did not create a transitional joint mechanism, or “backstop,” to help recapitalize or wind down lenders. However, if the ECB finds banks are in bad shape next year then eurozone states could find themselves with the same choice of ruining their finances or seeing banks collapse.
“It would risk financial instability if it exposed a bank as undercapitalized that has no access to outside capital,” Muenchau said.
Eurozone states could try to tap the bloc’s European Stability Mechanism bailout fund, as Spain did for its banks, but the money would come with tough conditions.
However, Veron believes that the ECB cannot afford to fudge the review of the banks.
“The risk is that, if the assessment fails to be consistent and rigorous, the ECB may find its reputation so damaged that the credibility of its monetary policy — and the perception of Europe’s ability to get anything done — could be affected,” he said.