When the European Central Bank stress tested its 130 largest banks for soundness, financial markets breathed a sigh of relief because all of the biggest banks made the grade, with smaller banks showing mostly fixable deficiencies. But just how stressful were those tests, and how meaningful are the results? And does a clean bill of health for most of the banks mean they will crank up lending now and help pull the eurozone out of its six-year economic malaise? To find out, Knowledge at Wharton interviewed Wharton finance professor Richard J. Herring.

An edited transcript follows:

Knowledge at Wharton: Could you tell us a bit about the background behind these tests and what they might mean?

Richard J. Herring: It’s an interesting lineage. To see the inspiration for it all, you really need to turn back to 2009 in the United States. Most people now mark that as the turning point in our crisis where we regained confidence in banks, and it was a similar exercise. The bank regulators devised a stress test with three scenarios and insisted that banks show that they could remain adequately capitalized even under the worst scenario.

The interesting thing about our experiments is that they forced 19 banks to undergo the experiment, and 10 of them failed. Ordinarily, you’d think that was not a good outcome. But it was accompanied by the SCAP program, so immediately they were forced to take funds from SCAP to recapitalize, which they repaid over time.

Knowledge at Wharton: What is SCAP?

Herring: SCAP is the Supervised Capital Adequacy Program, [which is similar to] TARP, the Troubled Asset Relief Program…. The Europeans tried it, seeing that it really did work in the U.S. I think it worked only because we had that very deep government pocket backing it up. The problem with Europe the first time they tried it is that [Europe is] really a group of independent states, and each have national champion banks. Most of the supervisors do not want to say anything harsh about their banks. So they did a stress test, but it wasn’t really very stressful. And a few days after it completed, the Irish banks went under. The state of Ireland tried to bail them out, but it went under and set off the debt crisis.

“One of the fundamental problems in Europe is that European banks tend to hold large amounts of sovereign debt.”

Knowledge at Wharton: That’s egg on your face.

Herring: Absolutely. And the second time they tried it, it wasn’t a lot more convincing because there, again, you had a major player that succumbed within a month or so. This time the stakes were much higher because the EU has decided to have a single banking authority. They are trying to integrate regulation and supervision of the entire banking system in the euro area. And the European Central Bank (ECB) is going to take it on as a subsidiary.

This has been years in the negotiation. But the debate, which was mainly the Germans against everybody else, was: “What do we do with the losses that are already in the system?” And they said, “Looking ahead, we can anticipate that we would have some sort of mutual obligation to support the system going forward. But we do not want to be on the hook for legacy losses.” That was what this was designed to do.

Knowledge at Wharton: So this [stress test] is more of a true exam than a little minor quiz, which seems to be what they had in the past.

Herring: We still don’t know for sure because only time will tell, but there’s every reason to believe it was much more serious. They were very much aware, first of all, that the odds are higher because after this, the ECB owns the problem. So, if you accept a dodgy bank from one of the nation states, there are costs to everybody in the rest of Europe.

Secondly, they were aware of the tendency of a supervisor to perhaps be a little bit gentle with their own supervisees. And so they designed examination teams that included a national supervisor, but also a supervisor from another country and a supervisor that was hired by the ECB. You had essentially three different perspectives and a much greater chance that you were going to actually get it right.

One of the surprising things about the U.S. was when they finally got around to announcing the results of the stress test, we were already in a more stressful macro situation than the [worst case] stress scenario. So that, too, makes it a bit puzzling that it worked. In the European case, people have been concerned that [the test] didn’t consider what many people worry about in looking at Europe, such as a deflationary impact. So there are always issues about that.

But there are also technical issues about the way in which stress was measured. They looked to a definition of capital-to-risk-weighted assets that covered up at least two pretty serious problems. One, they used the definition of capital that included two categories of accounting terms that are no longer accepted internationally. One is they permitted banks to count deferred tax assets. That’s fine if you’re going to make profits in the future. But if you’re a bank that is headed for resolution, that’s not going to be worth anything. And [two,] they also permitted banks to count goodwill. You can ramp up good will however you like by simply overpaying the accountants, and make the charitable assumption that you knew what you were doing.

Knowledge at Wharton: It’s the ultimate asterisk?

Herring: Absolutely. And then the denominator is fudged, too, because they maintain the polite fiction that all government debt is riskless, that it will be repaid in full. Yet, one of the fundamental problems in Europe is that European banks tend to hold large amounts of sovereign debt. And although it’s diminished a lot since the crisis began, there are large amounts of cross border debt. If you assume the Euro’s going to work and that everybody will be repaid, there was a real tendency to put the higher interest rate stuff — that was in riskier countries — in your books.

Knowledge at Wharton: You said they weren’t taking into account possible deflation in Europe, which has been a threat since the crisis began, but recently is seen as an even greater threat because inflation seems to be dropping even more. Is this a case of generals fighting the last war – where these stress tests would have prevented catastrophic failure if it was the same kind of crisis we had in 2008? But of course the next crisis is likely to be different.

“It’s now pretty clear … that the problem is that demand is much too weak, and they’re going to have to focus on that.”

Herring: I put it a little differently. I think they were trying to remove one part of what they viewed as deflationary pressures. The concern had been that European banks were so weakly capitalized that they really couldn’t provide loans that would help fuel recovery in Europe. Now it’s well to remember that, in Europe, this is a much more serious problem than it would be in the United States. Not that our banks aren’t important, but they account for about 20% to 30% of lending, and in Europe it’s more like 70% plus. So having a banking sector that is not able to supply credit to the private sector means that you’re really not going to have robust growth.

So part of the idea behind these tests was to … remove from the public debate [the idea that] the problem is that our banks are too weak. It’s now pretty clear, if you believe the test results, that the problem is that demand is much too weak, and they’re going to have to focus on that.

Knowledge at Wharton: That’s a big change. So it’s not a lack of confidence in the banks that’s keeping the European economy so far below its potential for the last five or six years?

Herring: We hope that’s true. There were some indications in terms of the rates that banks paid right after the test that there was at least some positive movement and confidence in European banks. It’s the same problem we faced in the U.S. — why is it we don’t see more bank lending? Is it because banks are trying to de-lever and don’t want to make loans? If you ask banks, they say they’ve never been more liquid, they’re always looking for opportunities. Or, is it because there’s not as much demand? That’s what banks say, but when you talk to the entrepreneurs and people who are looking for mortgages, they say they are really tough to get. So it’s hard to measure.

Knowledge at Wharton: You would think there would be some way to know what was really going on there — but the evidence is just conflicting.

Herring: We haven’t been very good at sorting out the effects of the rationing of credit. We know that rationing takes place. But are we not seeing more robust demand because the demand isn’t there from entrepreneurs and investors … or because banks just don’t feel strong enough to lend? They may have, as in the case of Europe probably two years ago, weak assets they haven’t revealed yet, and so they want to try to build up earnings to be able to somehow absorb the losses before they have to make them public. It’s complicated.

Knowledge at Wharton: It’s been a week now, and the markets seem to have accepted the verdict of the ECB in these stress tests, as you say, at least for now. But they didn’t react in a way that said, “Oh, these tests were just a fiction.”

Herring: No, they didn’t, and that in itself was a triumph because this was a really difficult test for the new European banking authority. This was essentially how you were going to qualify banks to enter the new system. If it had been a complete softball sort of test, and they passed everybody — as someone Europeans thought they would because they argued they had all been raising capital for a while — I think it would have had no credibility. We’ve seen that movie before, and we know it ends badly.

On the other hand, they were in a position where, if they actually were to fail one of the very large banks, it isn’t clear they had the mechanism in place to resolve it because there really isn’t that much funding at the European level. Depending on which state it is, they may or may not have enough funding to do it.

“If it had been a complete softball sort of test and they passed everybody … it would have had no credibility.”

Knowledge at Wharton: So this was the ultimate curved test in a way. They wanted to have some failures?

Herring: The largest was the oldest bank in the world, Monte dei Paschi di Siena.

Knowledge at Wharton: Right. And I think their stock dropped….

Herring: 20%, I think, from a not very high level I would add.

Knowledge at Wharton: One of the numbers that was buried in the report, but which a couple of analysts did pluck out, was something called the comprehensive assessment of the stock of bad loans … basically bad loans, loans that have a high chance of never being paid back…. The total number was really big – over a trillion dollars … and they uncovered something like 138 billion euros more in these non-performing or bad loans [that the authorities did not expect]. It’s a big number. It’s 9% of the eurozone’s GDP.

On the other hand, the authorities said that the banks’ capital shortfall was only about 25 billion euros. So I just wanted to find some way of reconciling that big gap. You’ve got all these potentially bad loans, but they’re telling the banks, oh, you’ve only got to increase your share of money [reserves] that you’re holding onto to account for that by 25 billion.

Herring: Well, it’s a little more complicated than that … and, by the way, it’s typical of any bank examination process that examiners will find assets on the book that they think are not properly valued. And they will almost never say something is undervalued. Almost always one of the results is, “Look, you’ve got this many more assets that we think are dubious. In order to get to a safe and sound position, we want you to accumulate more reserves, and that means provisions out of current income so that if these assets should go bad, it won’t affect your income or capital.” So, you’re anticipating the worst.

Now, these are forward looking, and that’s one of the fascinating features of the stress test. It’s a real sea change in the whole attitude towards bank supervision. Before the crisis, virtually all bank supervision was looking at what we see in today’s figures, which is like looking at the future through a rear view mirror. These [tests] try consciously to look ahead by forecasting what your position will be under a variety of positions.

The notion behind these assets would be that these assets might well not be paid in full. The number is less than people thought it would be. So in that sense, it was a pleasant surprise. People thought it would be even worse. But in fact, depending on the definition they use — and I haven’t looked at the document carefully enough to know — typically you’ll start classifying loans or assets according to how much past due they are. And typically in the U.S., you’ll use a 90-day period. And if they remain not paid for longer than that, you are supposed to allocate more and more [to reserves] so that unless it happens just abruptly, by the time you finally have to declare a loss you will have reserved enough to be able to absorb it.

Knowledge at Wharton: What else should we know about this?

Herring: It all sounds like a within-the-EU kind of issue that is more than a little technical. But we actually do have a lot riding on it. If the European banking system doesn’t regain health, not only is it a problem for our financial system, but it’s a huge problem for the European economy. And they have been a significant source of aggregate demand in the world. We could hope that they would finally get there, not only for their sake but for everybody else’s as well.