Patience Wheatcroft: If Europe’s banks fail again, will Germany step in?

The markets believed him, despite the rest of his speech that day hugely exaggerating the reforms that had been achieved within eurozone countries in moving towards convergence of their economies. Perhaps they ignored the first part of his speech, in which he said people had likened the eurozone to a bumblebee, which “shouldn’t fly but instead it does”. The financial crisis, he went on, had made it clear that the eurozone had to graduate into being “a real bee. And that is what it is doing.”

But a bumblebee is a real bee. The risk is that the euro is simply not designed for sustained flight. Unless the southern countries can be persuaded to drastically alter their employment regimes and increase productivity, they will be a dangerous drag on the single currency. Even if they can become more competitive, their prodigious levels of debt continue to look precarious. Greece, with debts still running at 150 per cent of GDP, limps on until, inevitably, it admits that, again, it cannot honour its obligations. Portugal, with debt at 125 per cent of GDP, also looks to be in an unsustainable position.

The only hope for the eurozone is, as it always has been, that Germany will eventually agree to redistribute the proceeds of its hard work to bail out the reprobate South. Understandably, ordinary Germans find this an unattractive proposition.

Yet there has been a widespread wish to share Mr Draghi’s belief that the ECB will be able to do enough to keep the euro in flight. Only last year, a financial crisis in Cyprus resulted in depositors having to bear some of the cost of a bank collapse, but it did not seriously dent confidence in the euro. The ECB, along with the International Monetary Fund, came up with a package to bail out the Cypriot economy, and therefore the single currency, but only on condition that the bank was allowed to default.

The fact that many of the depositors who lost money were wealthy Russians may have helped explain why there was not more widespread agonising over the fate of the bank. But if it were to happen on a wider scale across the eurozone, faith in the currency would undoubtedly take a drastic knock. Hence the fear that was occasioned last week by doubts over the finances of Banco Espírito Santo, an offshoot of a family empire which has hit difficulties in its other enterprises.

While the bank denies any financial problems, analysts estimate that it may be in need of another €2 billion or €3 billion of capital. By the time the European Banking Authority and the ECB have concluded their latest stress tests, the betting is that a slew of banks will be forced to raise new capital. The banking problems are even thought to be rife in the that poster economy of the eurozone, Germany, where it is said that several of the Landesbanken, the local banks that have traditionally been stalwart supporters of the middle-sized companies so important to the German economy, have not been sufficiently conservative.

These are not the first European-wide stress tests to be conducted but they are likely to be much tougher than those before. The embarrassment of seeing some banks sail through previous tests only to then be found in dire trouble is not likely to be one the authorities wish to repeat. So banks will be forced to remove any rose-tinted spectacles when looking at the assets and loans they acquired in boom times and acknowledge the losses. Then they will be judged on how they would survive if conditions were to turn nasty again. The result is likely to be another round of capital raising on top of the €100 billion in extra capital which European banks raised in the nine months to April this year.

The scale of the shortfall is testimony to the irrational exuberance that the banks exhibited during the good times. Prudence is painful.