The procedure goes by the name of the Asset Quality Review, which will judge whether the assets and capital of Europe's 130 leading banks are worth what the banks say they are or whether they are a great deal more vulnerable than the banks want to admit.
The background is important. Europe's banks have performed pitifully since the financial crisis began in 2007, in part because they didn't undergo the cuts and reforms of their U.S. counterparts.
The difference was that the U.S. banks were subjected to a strenuous and transparent stress test that wrenched a lot of skeletons from many cupboards. The Europeans, by contrast, were put through much gentler and less open stress tests that barely deserved the name, largely because of political interference by various national governments. European banks that "passed' the test have since gone under.
There are many and complex reasons why U.S. banks have recovered while European banks have not, starting with the greater vigor of an U.S. economy fueled by better demographics and the shale natural gas revolution.
But one key reason is that the reform process in the United States led banks to write off around $1 trillion, while their European counterparts wrote off less than half that amount. The U.S. banks were made to come clean. The Europeans weren't.
One way to look at the consequences is to see what the markets think. In 2007, of the world's 25 top banks the Europeans had almost half of the sector's market capitalization and were worth about $1.5 trillion. Today, they have about 18 percent, with a market cap of $492 billion.
There are other ways to measure what might fairly be called Europe's banking disaster. In the last five years, they have lost about $100 billion in annual income. Their Return on Equity was 20-25 percent before the crisis and down to single digits these days. The tougher new rules on the capital reserves and ratios that banks must maintain in future will squeeze ROE even further.
Most European banks are currently valued by the market at less than their book value, which means they would be worth more if broken up and sold than they are now. In other words, they are worth more dead than alive.
At the same time, the banks face critics in government and among their clients who say they are failing to lend and are thus stifling recovery. (How the banks can increase lending while facing tougher capital reserve requirements is a logical impossibility that only a politician could ignore while keeping a straight face.)
The banks are still deep in trouble. The Bundesbank, Germany's central bank, reckons that the country's seven largest banks need $43 billion in new capital. Last year, the banks of Europe's fringe economies (Portugal, Ireland, Italy, Greece, Spain and Cyprus) lost a total of $73 billion between them.
It is high time that Europe's banks were given a genuine and transparent review by an outside regulator. This is what the European Central Bank's AQR is meant to provide by providing the first trustworthy measure of just how much good capital the banks hold.
There are two obvious issues.
The first is the way the various banks define non-performing loans and the value they are given on the banks' books. Banks in fringe countries are said to be rather more forgiving than the AQR is likely to be.
The second is the quality of the sovereign bonds that the banks hold and banks in Spain and Italy have been loading up on their own national bonds, since the interest rate is good and this reinforces the symbiotic (but possibly dangerous) relationship between the banks and their governments. But are the bonds of Greece, Cyprus or Italy really worth their face value?
One key factor here is the reputation of the European Central Bank itself. For its own integrity, as ECB President Mario Draghi said this month, the AQR has to be seen to be thorough, transparent and honest. That means governments are going to have to grit their teeth and let the ECB do its work without any of the discreet political pressures that European officials and statesmen so discreetly and silkily apply.
The stakes are very high, for Europe's bank, for the central bank and for the overall prospects of the European economy. As the International Monetary Fund noted last month, slow or piecemeal reform measures "could further undermine confidence and lave the euro area vulnerable to renewed stress."
But if the ECB lives up to its promise and the Asset Quality Review proves to be reliable, then the European banks should be able to bite the bullet and clean up their act and then recover as their U.S. counterparts have done. Just don't expect them to start making generous new loans in the process.
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