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George Osborne, the UK Chancellor of the Exchequer, wrote a column for the Financial Times in which he called on the European Union to establish a credible plan for its banking systems.

On Thursday in Paris, European leaders are being brought together by the French government to discuss the year ahead. The top priority for the Group of 20 leading nations this year is to ensure a sustained global recovery that lays the foundations for stronger, sustainable growth. What does this mean for Europe? Addressing global economic imbalances cannot be code for a discussion between America and China, in which European countries are bystanders. On deficits, growth and banks, 2011 is the year Europe must put its own house in order.

This means confronting the difficult issues holding back confidence and growth. The first is continuing market concern about sovereign debt. The sense of crisis may have eased, but wide spreads and high market interest rates still stalk several European economies. We need a comprehensive package early this year to address this. The eurozone must follow the logic of the single currency and stand more convincingly behind the euro.

...These measures alone will not be enough to restore sustainable growth without a credible plan to reform and strengthen Europe’s banks, the second difficult issue that must be confronted. Weak banks act as a brake on recovery. The inability of many European banks to absorb losses on their balance sheets was at the heart of the crisis and underpins much of the current market uncertainty.

In the short term we must ensure that banks have the support they need to withstand market concerns. This is precisely why Europe’s leaders agreed last month to new banking stress tests. It is revealing that the tests conducted last July identified a capital shortfall of just €3.5bn. Yet less than six months later, Irish banks required 10 times that amount. That is why the UK has already gone further with tougher stress tests that mean our banks are well capitalised. Europe cannot repeat the same mistake again. It is now clear the new stress tests must be much tougher. They should cover a three-year period and look at liquidity as well as core tier 1 capital. We should look at ways of strengthening the credibility of these tests, including validation by bodies such as the International Monetary Fund. And where the tests show it to be necessary, banks must raise high-quality capital from either markets or, in extremis, national governments to secure their future.

As has been said repeatedly on this blog, there is one simple way to strengthen the credibility of the stress tests: provide the credit markets with the asset-level information so that analysts can independently run stress test scenarios and confirm the findings of the government designed tests.

In the absence of providing asset-level information, governments have little credibility with regards to the stress tests. The very fact that all the European governments, including the UK, are unwilling to provide the asset-level information strongly suggests there is something to hide.

Face with this fact, investors are simply not rewarded for failing to adhere to the adage 'fool me once, shame on you; fool me twice, shame on me."

For the longer term we need to strengthen Europe’s banks so that they, and not taxpayers, pick up the bill for future crises. Basel III contributes to this in several ways: increasing the quality and quantity of bank capital, as well as setting out a single definition that will underpin the single market; introducing new liquidity requirements; moving over time to a binding leverage ratio as a backstop to reduce funding risks; and ending the double-counting of the old regime for items such as insurance capital held by banking conglomerates.

The only way to strengthen Europe's banks is to disclose all of their asset-level positions. This lets the credit markets, including others in the banking industry, determine who is adequately capitalized and who is not adequately capitalized.

Based on this determination, investors and banks will be comfortable investing in and lending to the solvent banks without the need for any government guarantees and the expectation that they will suffer losses in the future if these banks encounter financial difficulties.

As for the banks that need to be recapitalized, so long as the government guarantees are in place and there is no risk of loss, investors and banks will continue to invest in and lend to these banks. This provides European governments time to either recapitalize or close the banks.

...The goal of a stronger banking system is so important that we must not allow unnecessary distractions in other areas to get in the way of agreement.

Disclosure: I have no positions in any stocks mentioned, and no lans to initiate any positions within the next 72 hours.
Source: 2011: The Year Europe Must Put Its House in Order