ECB fails 25 banks in stress test; problems mainly at smaller ones by Geoffrey Smith @FortuneMagazine October 26, 2014, 11:40 AM EDT E-mail Tweet Facebook Google Plus Linkedin Share icons The European Central Bank said Sunday that 25 out of the Eurozone’s 130 banks failed this year’s stress test, a landmark event before it takes over responsibility for supervising them itself. In all, the results suggest that any remaining problems of under-capitalization in the Eurozone are concentrated in the region’s smaller or medium-sized banks: that’s a view that will raise eyebrows in the U.S., where regulators are concerned about the balance sheet strength of some of the largest players such as Deutsche Bank AG DB . Out of the 25 that failed, nine were based in Italy, whereas the major banks of France, Germany all emerged unscathed. Most of the other failures were in Greece, Cyprus and Slovenia, while Spain, which took a multi-billion euro bailout from the Eurozone and International Monetary Fund in 2011 to help its banking system get over the collapse of a real-estate bubble, had no failures at all. The stress test was a snapshot aimed at seeing whether banks had enough capital to withstand a two-year recession and a fresh bout of turmoil on financial markets. It used end-2013 balance sheets as its benchmark. The ECB said that, out of those that failed, 16 had already raised enough capital since the end of 2013 to pass the test. The nine that haven’t now have two weeks to come up with plans on rectifying their shortfall, which must be implemented within nine months. The pass threshold was a ratio of 5.5% of top-quality capital to risk-adjusted assets. The total shortfall of the failed bamks was €24.6 billion ($31.2 billion), a figure that falls to €9.5 billion after this year’s capital raisings. The test, which covers over 80% of banking assets in the Eurozone, has taken up an unprecedented amount of time and money. Its aim was to ensure that the ECB wouldn’t be taking on any ‘unexploded bombs’ in November, when it assumes formal responsibility for supervising the banks affected, and that, in future, markets would put more faith in the credibility of the ECB as supervisor than they had in national ones. In contrast to the U.S., the Eurozone was slow to recognize the scale of the problems in its banking system after to 2008 crash, largely because many countries couldn’t afford the bill for rescuing them. As a result, Europe’s first attempts to restore confidence with “stress tests” failed miserably because politicians didn’t have the courage to acknowledge the problems at important banks such as Franco-Belgian lender Dexia SA and Spain’s Bankia SA. If the number of banks failing and the size of the capital shortfall announced Sunday again seem suspiciously small, and if the results again shy away from damning ‘systemically-important’ banks, that’s in part because those banks have raised substantial amounts of capital since the test was announced in July 2013. The ECB said that the 30 largest banks alone had raised €60 billion in that time and taken other measures such as selling assets to improve their balance sheet strength by a total of €200 billion. However, it also said that the 130 banks had overstated the value of their assets by some €48 billion, or about 2% of the total. In addition, the check has already flushed out weaknesses at banks such as Portugal’s Banco Espirito Santo SA (which had passed all previous stress tests done by the Bank of Portugal). ECB vice-president Vitor Constancio said the “unprecedented in-depth review of the largest banks’ positions will boost public confidence in the banking sector. By identifying problems and risks, it will help repair balance sheets and make the banks more resilient and robust. This should facilitate more lending in Europe, which will help economic growth. ECB President Mario Draghi has acknowledged that part of the reason why lending has been so shockingly weak in the Eurozone this year is that banks were unwilling to take on new risks while the stress test was still hanging over their heads. Loans to the private sector were down 1.5% in the year to August. Others were quick to sound a note of caution, however. Colin Brereton, a partner at PriceWaterhouseCoopers in London, said that passing a one-off test of solvency wasn’t the same as being a viable bank in the long run. “The point where many of Europe’s banks will be able to satisfy this long-term viability test is still a way off due to the prospect of continued weak economic conditions and low interest rates across Europe, an overhang of operating, compliance and restructuring costs, and mounting competitive threats from start-ups and non-bank challengers,” Brereton said.