Europe is paying the price. The uncertainty has made it difficult for banks to raise funds, creating a severe shortage of credit in some regions. Since businesses cannot obtain loans to invest in equipment or hire people, growth is at a standstill and unemployment remains high.
The best way to create confidence "is to recognize loans that are bad and write them off, " said William White, the former economic adviser to the Bank for International Settlements, the bank for central banks. The risk in not doing so, he said, is a cycle of stagnation like in Japan.
Doubts, too, persist about whether the European Central Bank president, Mario Draghi, will make the bold moves necessary to revive the moribund economy and combat the deflationary trend. While he has unveiled an aggressive plan to buy bonds and pump money into the economy, details have been limited. That vacuum has only fed market concerns about the weakness in the global economy.
"You could argue the falloff of the eurozone economy is at the epicenter of this," said James W. Paulsen, chief investment strategist at Wells Fargo Asset Management. With the current weakness, investors will now be paying close attention to the verdict of the bank review. "Three or four weeks ago, no one in the US would have cared," he said.
Europe's new banking overseer, Danièle Nouy, has vowed that the ECB. bank tests will be tough.
The review is part of a broader effort to create a uniform system of regulation for Europe's biggest banks, replacing a country-by-country patchwork of supervision that the financial crisis exposed as woefully ineffective. The new pan-European regulator, the so-called Single Supervisory Mechanism that will officially take charge on Nov. 4, has the broad powers to curtail risky behavior and impose penalties.
The head of the group, Ms. Nouy, a lifelong civil servant steeped in esoteric banking rules, has been on a hiring spree, helping expand a small army of civil servants and outside consultants to scrutinize banks' books. An estimated 6,000 people are involved in the review.
Compared with previous efforts, the ECB is taking a more comprehensive look, sifting through about 135,000 loan files at 130 of the largest banks in the eurozone as well as Lithuania, which will become the 19th country in the currency union next year. That amounts to 85 percent of banks' outstanding loans and other assets, according to the ECB.
The banks will also undergo a so-called stress test to see if they could withstand a major recession, bond market panic or other adverse situation. The ECB. has deliberately kept some of the methodology secret, to prevent banks from trying to manipulate the results.
Investors "will know what is in the balance sheet of European banks," Ms. Nouy said in an interview. "I am totally confident about that."
The main goal is to expose so-called zombie banks, lenders that have covered up deep problems by issuing new credit to troubled borrowers rather than allowing them to default. Lenders in Italy, Greece and Portugal are under scrutiny, given the weakness in those countries. Banks with a heavy concentration in certain industries, like commercial real estate, also face pressure.
For example, HSH Nordbank, a lender in Hamburg, has been hit hard by huge loans it made to the depressed shipping industry. The bank's position is considered particularly perilous because its options are limited if the ECB. finds a capital shortfall. HSH does not have a stock market listing, so it cannot sell additional shares, a standard way to raise more money.
HSH Nordbank declined to comment. But a person with knowledge of the ECB. examination said the bank had enough capital to pass the asset quality review.
Pressure from ECB. auditors has already helped uncover grave problems at one bank, Banco Espírito Santo in Portugal, which collapsed in August in the face of fraud accusations. The specter of ECB. scrutiny has also prompted a scramble for new capital to provide bigger cushions against potential shocks. Banks including Deutsche Bank of Germany and Monte dei Paschi di Siena of Italy have raised 200 billion euros, or $256 billion, since last summer, according to an ECB. estimate.
To truly clean up the system, Ms. Nouy and the rest of the ECB. have to be willing to force some harsh medicine on the banks -- and come to a consensus on those decisions. That hasn't always been easy, at least based on Cypruss experience.
By 2013, the ECB. had approved more than EUR9 billion in loans made by the country's central bank to its second-largest financial institution, Cyprus Popular Bank. The money flowed to the institution, which later changed its name to Laiki Bank, despite objections by one top official who said it was insolvent, according to previously undisclosed minutes of meetings held by the ECB.'s decision-making arm.