Column: The ECB’s mega-test

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SummaryA lot of the central bank's credibility hinges on the success of the clean-up of euro zone banks that it is overseeing

A lot is riding on the clean-up of euro zone banks being overseen by the European Central Bank. The progress so far is encouraging. But clarity is needed on a few points to ensure that lenders really do get a good scrubbing and are so able to support the zone's fragile economic recovery.

The ECB is in the midst of a so-called comprehensive assessment of euro zone banks. This has two elements: an “asset quality review” (AQR) to determine whether the loans and other assets held on their balance sheets are valued properly; and a “stress test” to check whether they could withstand a severe economic downturn.

To pass the test, banks are supposed to have a “common equity tier 1 capital ratio”, a measure of balance sheet strength, of 8% in the baseline scenario; and a ratio of 5.5% in the adverse scenario. The whole exercise is supposed to be finished by October before the ECB officially takes over from national authorities in November as lead supervisor for the zone's banks.

The hope is that investors will at last have confidence that the numbers in bank balance sheets are accurate and lend to banks more freely. Banks would also lend to each other. With the money markets functioning normally again, banks would have more confidence to lend to companies and consumers, giving a boost to economic activity.

That is what happened when the United States and the UK put their banks through severe stress tests five years ago. Unfortunately, the euro zone put its lenders through a series of sham tests. They gave clean bills of health to Irish, Spanish and Cypriot banks which virtually blew up soon after.

There are several reasons why things may be different this time.

For a start, this is the first stress test the ECB has overseen. It knows that if it flunks this exercise, its own credibility will be shot to bits.

What's more, this is first time the zone has put banks through an AQR. Previous exercises just had a stress test and so did only half the job.

Then there's the fact that the ECB is using multi-country

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