PORTO (Reuters) - Europe has to allow banks with unsustainable strategies to fail after years of debt and financial turbulence which showed banks' capital was far too low, European Central Bank Governing Council member Erkki Liikanen said on Thursday.
The main challenge, he said, is to implement a regulatory reform that will redirect the sector to support the economic recovery that has been very slow, while removing "perverse incentives" for banks to expand too much.
Analysts fear that the poor health of the euro zone's financial sector will dent recent signs of an economic recovery. Liikanen said Europe should be wary of this.
"It is essential that banks with unsustainable strategies are allowed to fail," he told a business conference in Porto in northern Portugal.
Both Liikanen and fellow ECB board member Carlos Costa urged European banks to ensure they had adequate capital buffers to face next year's stress tests under a new euro zone-wide banking supervision mechanism.
"We need to ask banks to have capital to absorb losses if needed," Costa said in a speech.
Liikanen, who heads Finland's central bank, said the crisis in Europe showed the importance of understanding when its banking sector is growing "excessively", noting that leading European banks are very large compared to international peers, particularly in relation to the size of their countries.
"No one knows what is the right size of the sector, but we can remove perverse incentives for too much growth," he said.
The ECB promised last week to put top euro zone banks through rigorous tests next year, staking its credibility on a review that aims to build confidence in the sector.
"We are in a critical phase before the supervision mechanism starts. It essential we ask banks in Europe to improve capital," Liikanen said.
(Reporting by Daniel Alvarenga; editing by Patrick Graham)
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