Asia not need to worry about health of European banks

The first comprehensive assessment of European banks, published recently, was generally positive, as many expected.

Only 16 banks out of 150 institutions failed to meet the minimum criteria of having 8 percent of risk-weighted assets matched by common equity tier-one capital, with an aggregate capital shortfall of 5 billion euros ($6.22 billion). Under more stringent scenarios, the shortfall increases to a maximum of 24.2 billion euros, spread between 25 entities. This is still a very modest amount, accounting for slightly more than 4 percent of total assets, especially since many banks have covered their capital shortfalls over the course of this year. At the time of writing, only 13 banks were still short of capital.

Another encouraging outcome of the stress tests was that banking systems that had to undergo serious restructuring since the worst of the eurozone crisis in 2011 and 2012 managed to pass. A good example of this is Spain. Two years ago the European Union had to bail out the country to help save its biggest banks. All have now passed the tests.

The results bode well for the European economy. They will enable the region to embark on its banking union project without serious concerns about solvency and asset quality. The project, which has been discussed since 2012, is aimed at a regional approach to regulation and supervision of euro area lenders.

However, the picture that the assessment paints is not entirely rosy, and many challenges still lie ahead. The biggest of these is the fragmentation of financial markets in the eurozone, including the money market. A healthy market is essential for a well-functioning monetary union.

Cross-border lending used to thrive before the sovereign debt crisis but money markets have grown increasingly national. This is extremely detrimental for the eurozone because it hampers the effective allocation of savings within the bloc.

In sum, European banks seem to have regained adequate solvency levels, but they are operating in a difficult and fragmented market. To what extent will this have an impact on Asia?

The easy answer would be to say that Asia does not need to worry about the health of European banks because of the abundance of domestic funds.

Although there is some truth in this, it oversimplifies the situation.

In particular, it ignores how Asia has benefited from international financial integration. In fact, European banks have long been a major source of crossborder lending globally, including in Asia. They have lost some market share due to rapid deleveraging since the global crisis, particularly in Asia. But they still hold the largest share of crossborder lending to Asia.

Their combined share of Asian bank borrowing has fallen to about a third of the total because of the arrival of new competitors, especially Chinese banks, but Asia's importance as a major lending destination for European banks has risen since the mid-2000s. In fact, Asia is now the second-largest destination for European loans after emerging Europe, with as much as $1 trillion worth of outstanding liabilities in the first quarter of this year.

For Asian economies with access to large amounts of domestic capital, this may still be a moderate amount. But it nonetheless shows that many borrowers in the region do make use of opportunities for geographical diversification when it comes to financing.

We also cannot forget that many Asian economies have accumulated large amounts of foreign reserves and have continued to diversify their holdings into euro assets. For those countries the renewed strength of European banks can only be good news, as it should reduce the likelihood of a new crisis in the euro zone, and, thereby, a potential sharp deterioration in the value of their portfolios.

At the same time, Asian economies with external financing needs should be very pleased with the renewed good health of European banks, because it should help them borrow from those banks. For Asian countries and businesses, European stress testing is neither remote nor academic.

The author Alicia LICIA Garcia-Herrero is chief economist for emerging markets at Banco Bilbao Vizcaya Argentaria. She also serves as special adviser to the European Commission on China issues.