Why the ECB asset-quality review will be no game-changer

Sid Verma
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Everything you thought you knew about the ECB’s comprehensive assessment was wrong – it won’t reveal large holes in banks’ balance sheets.

The ECB’s comprehensive assessment – which consists of three legs: identifying portfolios that need scrutiny; the asset-quality review (AQR); and a stress test to be completed by October 2014 – is turning out to be a largely different beast, compared with previous market consensus.

Here was the bullish view that prevailed this summer:

1. After the European Banking Authority’s (EBA) failure to shore up market confidence through a rigorous assessment of the health of eurozone banks, the ECB was expected to use its first opportunity as lead regulator to fail at least some institutions in its stress tests.

2. In a nod to critics who say eurozone banks’ continued dependence on central-banking funding at low rates, combined with their unhealthy quantum of sovereign bond holdings, undermines the spirit of the AQR, the ECB would test banks for their financing firepower in private markets and the extent to which a sovereign default would deplete their capital.

3. Amid fears over inadequate or disparate bank-accounting norms, the ECB would audit the majority of regional banks, through a standardized methodology, to ensure corporate loan books are sufficiently provisioned for.

4. The stress test – largely based on the 2016 Basel III rule on common equity core tier 1 – would finally lay to rest investors’ fears over the health of eurozone bank balance sheets.

5. Credit growth and banks’ holding of risky assets would remain weak but financial fragmentation, and fears over the Japan-like zombie banking system, would at last recede with financial institutions, especially in the periphery, recapitalizing en mass.

Instead, imagine the following scenario:

1. The AQR will be a non-event to investors. There won’t be a big showdown between the ECB and financial institutions on capital – as banks are already gradually recapitalizing while there are a lack of subordinated debt securities in core Europe that can be considered bail-in-able for the purposes of the AQR.

2. Contentious issues, such as sovereign debt holdings, central-bank financing and leverage will be largely postponed, in part, thanks to the logistical challenge of assessing the books of at least 128 of the large banks in the euro-area in time for the tight deadline.

3. The ECB/EBA standard for NPL provisioning won’t be applied for the entire loan books of European banks.

This scenario is the call from bank analysts at Exane BNP Paribas. They reckon the ECB will focus on less-contentious issues, such as commercial real estate, shipping and leveraged SME loans, and the valuation of Level III bank assets, rather than comprehensive sovereign debt reviews and new risk-weighting rules, as well as pronouncements on funding and leverage risks.

The bank analysts also conclude the comprehensive assessment is “unlikely to be a trigger for major capital issuance in the quoted European banking sector” and none of the banks, under its coverage, is likely to fail the stress test, in stark contrast with speculation the eurozone is poised to face its Tarp moment of bank recapitalizations in full public glare.

It concludes: “It is unlikely that the AQR will be calibrated so as to create any capital shortfalls larger than the ability to meet them by mergers, asset sales and the limited resources of peripheral sovereigns. Such a calibration would be unlikely to deliver material shortfalls in the quoted sector.”

What’s more, since preference shares and subordinated debt have been sold exclusively to retail customers in Spain and any bail-in moves would require an act of emergency primary legislation, the ECB is unlikely to announce “major capital shortfalls” in the Spanish banking system, according to Exane BNP Paribas.

“[These factors] seem to us to present a high degree of political difficulty, and we suspect that the ECB – which has to balance its overall monetary and financial stability roles – might not wish to trigger a political crisis,” it states.

Mario Draghi, president of the ECB
“This issue is exacerbated by the decision of the European Commission’s competition directorate – and its commissioner, Joaquin Almunia – to refuse to grant president [Mario] Draghi’s request for a waiver to the Commission’s new rules requiring a bail-in of at least 8% of total liabilities as a precondition for approving any state-aid packages.”

It continues: “It is likely that the ECB had requested this waiver because it wanted more political flexibility – as it is, any result of the AQR which finds capital shortfalls which cannot be made up by retained earnings in a non-quoted bank will necessarily trigger exactly this kind of issue.

“This reinforces our assessment of the likelihood that AQR will not find any major capital shortfalls.”

The argument that the regulatory exercise will face hurdles in revealing big holes in bank balance sheets – thanks to the logistical feat of achieving consistency and transparency when assessing eurozone banks’ asset quality – was backed by an official at the Financial Stability Board at Basel, who told Euromoney in Washington in October: “The single biggest challenge the ECB faces is the logistical challenge of conducting all these complex investigations, in such a short period of time.

“Something has to give. I wonder whether the comprehensive assessment will be more modest in ambition.”

Instead, the process – rather than the AQR event, known as the supervisory risk assessment (SRA) – will prove more decisive in shaping capital, liquidity and funding risks for problematic banks, away from public channels, according to Exane BNP Paribas.

The SRA is an ongoing review that assesses both a bank’s intrinsic risk and that relative to its peers, which, according to the EC’s official document, forms a key plank tool in the single supervisory mechanism.

Exane BNP Paribas analysts reckon this could be the game-changer, though few details have been released.

“This [SRA] appears to be the framework for developing a European equivalent to the US regulators Camels (capital, asset quality, management, earnings, liquidity and sensitivity to market risk) framework, which gives banks a score between one (best) and five (immediate remedial action required),” they state.

“From the few clues given in the description, it appears that the SRA is the place where the risks associated with funding and leverage ratios will be taken into account, and it appears that they will be assessed in a qualitative rather than quantitative manner.”

In conclusion, the comprehensive assessment might fail to reveal gaping holes in banks’ balance sheets or issue pronouncements on sovereign debt holdings, central-bank financing and leverage.

If analysts at Exane BNP Paribas are right, the ECB might only identify “major capital shortfalls” at unlisted banks, and identify the need for beefier accounting and write-downs on well-known legacy challenges: real estate and shipping loan books, as well as structured finance portfolios.

Still, if the ECB manages to assert its authority as lead eurozone bank regulator, boost market confidence and increase the transparency of banks’ assets, then the comprehensive assessment would be deemed a success.

After all, there has been a marked softening in tone by European officials in recent months in favour of regulatory forbearance, while market forces – financial institutions, seeking to avoid the political stigma of AQR and achieve first-mover advantage, increasing their loan provisions – are doing a part of the ECB’s job.