One reason the euro zone is in such a mess is that it has not had the courage to clean up its banks. The United States gave its lenders a proper scrubbing, followed by recapitalization, in 2009. By contrast, the euro zone engaged in a series of halfhearted stress tests that missed many of the biggest banking problems, like those in Cyprus, Ireland and Spain.

In recent years, Europe has started to address these problems on a piecemeal basis. But it is still haunted by zombie banks, which are not strong enough to support an economic recovery.

The European Central Bank now has a golden opportunity to press the reset button in advance of taking on the job of banking supervisor in mid-2014. It must not flunk the cleanup.

Mario Draghi, the E.C.B. president, is alive to the opportunity and the threat. His fear is that, even if the supervisor does its job properly, there will not be a safety net for troubled banks that cannot recapitalize themselves. This is why he called on governments last week to make an explicit commitment to provide such a “backstop.”

Mr. Draghi highlighted the contrast between the U.S. stress test, in which Washington committed to plug any balance sheet holes, and the last stress test conducted by the European Banking Authority in 2011, which lacked such a commitment by governments. The U.S. test started the American economy on the road to recovery; the European one set off a new phase in the crisis.

The moral is obvious: Without a safety net, shining a light on problems can provoke panic. The supervisor may as a result be tempted to continue sweeping problems under the carpet. The euro zone’s recovery would then be further delayed, and the E.C.B.’s credibility destroyed.

So far, governments have not responded to Mr. Draghi’s request for a backstop. In the meantime, the E.C.B. and the banking authority — which are working on different aspects of the cleanup — have many issues to clarify.

First, who exactly will review the banks’ assets? The E.C.B. does not yet have the manpower to do it. So it has to rely on national supervisors. The snag is that these supervisors could have an incentive to hide problems in their banks, so the cost of bailing them out is borne by the euro zone as a whole.

Mr. Draghi’s answer is to get supervisors to cross-check the balance sheets of banks in other countries — and to reinforce the audit’s independence by involving private-sector assessors. The latter suggestion originally provoked unhappiness in France. But at a recent dinner with central bank governors, Mr. Draghi pushed his solution through.

That still leaves the question of whether the E.C.B. can conduct a sufficiently in-depth review given that it wants to finish the whole process by next spring. It needs to figure out how likely loans are to turn sour and whether banks have taken adequate provisions against that possibility. About 140 of the euro zone’s top banks will be reviewed.

The E.C.B. should also look into whether lenders have used appropriate “risk weights” for their assets. A risk weight determines the size of the capital buffer a bank is required to hold. There is a widespread suspicion that many lenders are using artificially low weights to give the misleading impression that they are well-capitalized.

After the E.C.B. completes its review, the banking authority will conduct a stress test to check whether banks can survive a shock. This raises many other questions, on matters including how big a shock it will test; how much capital banks will need to have in this stressed scenario; and how long they will get to restock their capital if they fail the test. If the banking authority is too soft, the test will be exposed to ridicule in financial markets.

Yet another issue is whether capital shortfalls will be expressed as an absolute number — like €1 billion, or $1.3 billion — or as a percentage of risk-weighted assets. The last banking authority test plumped for the percentage method, with the disastrous consequence that many banks solved their capital problem by selling assets and stopping lending — and thus further crushing the economy. Ewald Nowotny, an E.C.B. council member, suggested to Reuters last month that this error would not be repeated.

Once all this is dealt with, the question then becomes who will provide a backstop in the event that a bank has a capital shortfall that it cannot fill itself, and its government has too much debt to help out.

One option would be for the European Stability Mechanism, the zone’s bailout fund, to inject capital directly into banks. But Germany seems to have rejected this.

The main alternative is that the stability mechanism should lend money to national governments, which could then inject it into their banks. That is what happened last year when Spain’s lenders got into trouble.

The snag is that this would add to the government’s deficit and debt. A partial workaround could be for the European Commission to ignore any capital injections when it determines whether governments are doing enough to cut their deficits. Without such forbearance, the countries could be forced into another round of growth-pummeling austerity measures.

With so many issues to resolve, there is a risk that Europe’s megabank cleanup will either be another damp squib or even create more damage. Having wasted five years failing to address the problem properly, the euro zone must make sure this does not happen.

Hugo Dixon is editor at large of Reuters News.

Article source: http://www.nytimes.com/2013/06/10/business/global/10iht-dixon10.html?partner=rss&emc=rss