1 Falling Short of Expectations? Stress-Testing the European Banking System

The eurozone is mired in a recession. In 2013, the GDP of all 17 eurozone countries fell by 0.5% and the outlook for 2014 shows considerable risks across the region. To stabilize the common currency area and its (partly insolvent) financial system, a eurozone banking union is being established. An important part of the banking union is the Single Supervisory Mechanism (SSM), which will transfer the oversight of Europe’s largest banks to the European Central Bank (ECB). Before the ECB takes over this responsibility, it plans to conduct an Asset Quality Review (AQR) in 2014, which will identify the capital shortfalls of these banks.3 The banking systems in the eurozone have been severely under-capitalized since the 2007-2009 financial crisis. As a result, some banks loaded up on risky assets (and risky sovereign debt in particular). The worsening risk profile of these assets destabilized banks even further and resulted in substantial liquidity and solvency problems by the third quarter of 2011 (Acharya and Steffen, 2013). Too little capital in the banking systems appears to have also caused a misallocation of credit in the euro area, especially for small- and medium-sized enterprises (SMEs), preventing a widespread economic recovery. A comprehensive and decisive AQR will most likely reveal a substantial lack of capital in man