ECB asset quality review is moment of truth

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Europe’s Tarp moment could be looming as ECB president Mario Draghi issues a sharp warning that the year-long review of the region’s banking system will be credible and might require public backstops. Many long-neglected issues are coming to a head, from accounting and bank-reporting norms to national regulatory conventions. However, there is no clarity yet on the hot-button questions.

Banks in Europe’s periphery were already selling non-strategic stakes and raising equity as the European Central Bank launched its asset quality review in October. With analysts worrying about a looming moment of truth for mid-tier banks and the possibility of recapitalization through bail-in threatening to destabilize the bank subordinated debt market, ECB president Mario Draghi has been pressing for clarity over allowance for public capital to be injected into banks.

Mario Draghi, president of the ECB
Could it be Europe’s Tarp moment that is looming? While European banks rescued piecemeal by separate national authorities in the depths of the crisis have been shedding operations and market share in recompense for state aid ever since, it was arguably the comprehensive Tarp programme passed five years ago that helped restore US banks to the point where they could lend to the real economy.

In Washington in October, the coffee-break chatter among European bank regulators mainly concerned fears that the time pressure on the ECB to conduct its review of Europe’s largest banks before becoming their lead regulator next year might preclude it from doing a thorough job.

Yet the ECB has a full year. It will start its review in November; complete its assessment in October 2014 and make public recommendations of measures for banks to undertake before assuming its supervisory role in November 2014.

The ECB has made clear that the aim of the whole exercise – by imposing some uniformity and transparency on bank reporting as well as dictating repair of any balance-sheet problems – is to assure stakeholders that banks are sound and trustworthy. The outcome is already decided. To achieve it, the process has to be credible. With its own reputation at stake as the lead regulator from next November, the ECB has to pick away at some of the fudges national regulators have connived at along with the banks in their charge to prop up domestic financial systems.

It’s a big job. On the eve of its launch, the asset quality review grew into the comprehensive assessment now also folding in, quite sensibly, the European Banking Authority stress test to follow. This might require further reinforcement of capital buffers in light of the ECB’s testing of banks’ forbearance of under-recognized and inadequately provisioned potential doubtful loans when these are then modelled against possible future economic and market downturns.

And the ECB will also gauge other key risks to banks beyond simply bad assets by looking as well at liquidity, leverage and funding. The ECB tells us that, jointly with national central banks and bank regulators, it is now in the process of developing a new risk assessment system for all this that will be deployed as a key supervisory tool in the future Single Supervisory Mechanism.

The lack of any further detail hints at the size and complexity of the task. Many long-neglected issues are coming to a head here on different accounting and national regulatory conventions and the inadequacy of banks' voluminous public reports in conveying a true picture of the risks they take as identified by the Financial Stability Board’s enhanced disclosure taskforce.

The comprehensive assessment covers 130 banks in 18 countries, accounting for approximately 85% of euro-area bank assets, making this the largest such exercise ever undertaken.

The note on the comprehensive assessment the ECB published at the end of October seems muddled at times. The ECB first says the asset quality review will be broad and inclusive, comprising credit and market exposures (including a quantitative and qualitative review of hard-to-value level 3 assets), on- and off-balance-sheet positions and domestic and non-domestic exposures. All asset classes, including non-performing loans, restructured loans and sovereign exposures, will be covered. It then appears to change tack and say that the review will concentrate on those elements of individual banks’ balance sheets that are believed to be most risky or non-transparent.

There is no detail yet on the obvious hot-button questions, such as whether haircuts will be applied to the domestic sovereign bonds that make up a growing portion of many European banks’ balance sheets in the EBA stress test to follow the review. The message is mixed, too, on the extent to which the ECB will call to account banks that have already gamed the system. The ECB says that a full assessment of internal models used for the calculation of risk-weighted assets will not take place within the comprehensive assessment, but adds that the outcome of the exercise will lead to adjustments in the risk weights, where justified.

Most telling is the ECB’s concern that, even before the assessment gets under way and capital shortfalls to the 8% common equity tier 1 ratio against reassessed risk assets are identified, banks and national competent authorities need to establish their capital backstops now.