By John O'Donnell and Eva Taylor
BRUSSELS/FRANKFURT (Reuters) - The European Central Bank's (ECB) plan to test the health of the euro zone's largest lenders without the means to plug any holes it uncovers risks foiling what some see as the bloc's final chance to put its financial crisis behind it.
Unlike in the United States, where rapid infusions of capital put its banks quickly back on track, Europe's financial system remains frozen, with lenders in countries such as Greece, Spain and Italy hurt by weak demand and soured loans.
To break the "doom loop" between indebted European countries and their banks and reassure investors that stressed euro zone lenders would be dealt with on a regional level, a banking union, with the ECB as supervisor, is viewed as crucial.
"The U.S. turned the leaf on its banking crisis in 2009," said Francesco Papadia, former head of the ECB's financial market operations, who helped guide the central bank's management of the financial crisis.
"Now the euro area has a great opportunity, probably the last one, to achieve this."
But the political will to forge full banking union has waned as the heat of the crisis has passed, and German reluctance to back a central fund that would potentially come to the rescue of any troubled euro zone bank means that the ECB is preparing to take on its role from late next year in a dangerous vacuum.
The ECB, both for its own reputation and the future of the bloc, is under pressure to ensure that banks undergo a thorough health check that will force them to recognize hidden losses.
But without a pan-euro-zone bailout fund, such tests could highlight problems without a convincing solution, potentially undermining the banking union project before it has fully taken off.
"To really solve the asset quality concerns, you need to have a backstop. If you find a gap, you need to be confident you can fix it," said Ronny Rehn, analyst at Keefe, Bruyette & Woods (KBW) in London.
"If you don't have this, then we might have to lie to ourselves again and say there is no problem because we couldn't afford to fund the problem."
CONFIDENCE OR COMPROMISE
The ECB wants to check the health of big banks, under a so-called Asset Quality Review (AQR), before taking over their supervision. This will also help shape wider testing of banks outside the euro zone, overseen by the European Banking Authority (EBA).
In Frankfurt, home of the ECB, there is growing resignation that a pan-euro-zone backstop is unlikely and that countries may be left to prop up their banks alone, as they were when the financial crisis struck.
"We'll have to have national backstops in place," ECB President Mario Draghi told the European Parliament earlier this week. "If it (single resolution scheme) is not there in place, it will be up to the national authorities ... which is suboptimal, of course."
Such a compromise exasperates bankers, who want confidence restored to the sector so their cost of funding drops.
"The ECB, EBA and EU are all saying that the AQR and stress tests will be stringent," said a credit banker at a large London-based investment bank. "It's easy for those to say that; they don't have to come up with the money.
"It's the government I want to hear it from. I want to hear from the government what happens if banks fail."
With confidence in European banks still low, the sector is valued at a significant discount to U.S. peers, trading at around par with the book value of its tangible assets compared with around 1.7 times for the United States, according to an analysis by KBW.
Europe's top 42 banks are already about 70 billion euros short of meeting new international capital norms, even before taking into account that they have often set aside too little to cover unpaid loans or an economic slump.
"We see a problem primarily in Spain and Italy, because that's where you have a housing market that's still in freefall," said Jon Peace, an analyst with Nomura. "The small banks have bigger problems than the large ones."
OUT ON A LIMB
Germany, the euro zone's strongest economy, which has shouldered much of the burden for country bailouts, does not want a scheme that leaves it on the hook. That aversion is unlikely to change, whatever the outcome of current government coalition talks.
Berlin has suggested that a bank resolution agency should only have power over the euro zone's largest lenders. That would reduce any potential bill to be shared by the 17 euro zone countries, but such a deal could mean that small risky banks, at the heart of the current crisis, slip through the net.
The absence of a financial backstop to help banks once their problems are laid bare may prompt the ECB to delay the tests of banks altogether, a move that could postpone supervision and damage the euro zone's image internationally.
The situation would be even worse if haggling between EU governments delays agreement - now penciled in for December - on the 'resolution' framework to cope with laggard banks.
That would have a knock-on effect on talks to finalize the regime with the European Parliament, potentially leaving the ECB out on a limb when it takes on supervision, as now planned, towards the end of next year.
"We will not start before governments have agreed on a backstop - emergency funding for capital holes - which we might find in the balance sheets," Yves Mersch, the member of the ECB's executive board in charge of supervision, said on Monday, referring to the bank balance sheet checks.
"This has nothing to do with sitting something out, but with responsibility," he said. "This assessment could throw us back into crisis, without clarifying the financing beforehand."
Putting off the day of reckoning could make the months ahead easier but would likely come at a heavy cost for the ECB, which has already lent the banks over a trillion euros in cheap funding, mostly now repaid, and is expected to open the taps again, possibly by the end of this year.
Most agree there cannot be a repeat of the two earlier stress tests, widely considered flops for a series of blunders, including giving Irish banks a clean bill of health months before their problems pushed the country into an international bailout.
Ex-ECB man Papadia warned of the consequences should "the ECB get scared" and soften its assessment of banks.
"The risk of this is that you would continue with the opacity ... where people suspect there are big problems but nobody knows where and how big they are," he said.
"The trust in the ECB would be affected, and, ultimately, there would be consequences even for the currency."
(Additional reporting by Laura Noonan and Steve Slater in London; Editing by Carmel Crimmins and Will Waterman)