Draghi turns judge on EU banks as ECB studies accounts

The European Central Bank is sizing up just how tough it wants to get with the region’s lenders.

Policy makers at the Frankfurt-based ECB will this week try to agree on the ground rules of its three-pronged probe into the health of the 130 banks it will start supervising next year. The process will stress-test balance sheets for exposure to sovereign debt as well as push institutions to admit to more of their bad debt than they have before, according to three officials who spoke on condition of anonymity.

The check-up due in early 2014 is the ECB’s precondition for assuming the burden of overseeing banks from Deutsche Bank AG to Intesa Sanpaolo SpA, and the first assessment of the industry since a round of stress tests two years ago. Already in charge of setting monetary policy, ECB President Mario Draghi is putting the institution’s reputation on the line as it balances rigor with caution in examining the euro-area’s fragile financial system and tries to prevent a repeat of the turmoil that set off Europe’s worst recession since World War II.

“The ECB can’t pull its punches,” said Richard Barwell, an economist at Royal Bank of Scotland Group Plc in London. “A stringent examination is the only pathway to a well-capitalized banking system. But it is possible to be too tough. Capital is there to insure against unexpected losses, but not against Armageddon.”

Stress Tests

The ECB’s three-stage process is called the Comprehensive Assessment — a risk analysis of banks to identify portfolios requiring scrutiny, followed by a close examination known as the Asset Quality Review, and then stress tests simulating the effect of a range of adverse scenarios.

Policy makers will gather at their mid-month meeting to discuss methodology for the exercise and how to release it, parts of which may be presented to the public next week, according to two officials briefed on the agenda who declined to be identified because it is confidential. The Governing Council, comprised of the heads of the euro-area’s 17 national central banks and the ECB’s six-member Executive Board, is scheduled to meet formally tomorrow. A spokeswoman declined to reveal the agenda.

The point, as explained by Draghi in Washington on Oct. 12, is to remove persistent doubts overshadowing Europe’s banking system at a time when he is trying to foster a recovery from a record-long recession. He said then that he wants to present investors with a “complete, fully transparent analysis” of its assets. More than that, the Banking Union, of which the ECB’s supervision is the first part, seeks to break the inherent link between a country’s bond market and the health of its lenders.

Bank Buffers

“The market will be looking for details such as the size of any additional buffer that might be required over and above the benchmark requirement,” said Nick Matthews, an economist at Nomura International Plc in London. “Other features such as harmonization surrounding non-performing loan identification and provisioning” will be closely watched too, he said.

The ECB will derive the rules for banks’ reserve cash buffers from new capital rules defined by the Basel Committee on Banking Supervision’s Basel III accord, Executive Board member Yves Mersch said in a newspaper interview this week. Mersch and ECB Vice President Vitor Constancio are jointly responsible for erecting the supervision pillar inside the ECB.

Mersch indicated that the ECB will use a benchmark of 7 percent core capital equivalent as a minimum to be held by banks, and that it would add a capital surcharge for large banks. Under existing rules, lenders will only have to hold core capital equivalent to at least 4 percent of their risk-weighted assets next year, rising to 7 percent in 2019. The large-bank surcharge only enters into force 2016.

List of Banks

While those hints signal a tough stance, much about how the ECB will fulfill its bank watchdog role remains unknown. That includes the list of 130 banks that it will supervise — at least the top three institutions from each country and those with total assets exceeding 30 billion euros ($40 billion). The ECB will compile the list using data at the end of 2013, but policy makers may still publish an indicative lineup as soon as next week, two officials with knowledge of the matter said.

The ECB’s assessments of lenders will contrast with two previous stress tests by the European Banking Authority by having at least “three pairs of eyes” cast over them, ECB Executive Board Member Benoit Coeure said on Oct. 13. They consist of checks by local supervisors, then the ECB, and then independent auditors, to overcome national bias, he said.

Book Value

Such scrutiny will help identify assets that are non-performing, overvalued or those that otherwise embellish balance sheets. Investor concerns that accounts don’t match up to asset values are one reason why listed European banks trade at only 0.7 times book value, while rivals worldwide trade at about a 1:1 ratio to their book value, Mersch said last month.

Officials are also grappling with how to clean up unrecognized bad loans. Their main tool to stop forbearance on such loans is to tighten and unify rules for how to book them. The EBA is due this month to agree on a definition that could be used as a template by the ECB. German banks have already warned against plans to apply the draft rules, evidence of pushback against harmonization that the ECB will need to contend with.

“So much will have to be done by the supervision authorities that were already in place,” said Guntram Wolff, Acting Director of the Breugel institute, a Brussels-based research group. “The incentive to really dive deep and to discover things that weren’t previously discovered is, of course, not large.”

Backstop Rift

Further undermining the ECB’s drive to fully assess the region’s banks is the lack of cash backstops to deal with whatever shortfalls emerge. At a meeting of European Union finance ministers in Luxembourg yesterday, a rift emerged between proponents of enhanced backstops and those such as Germany who maintain that existing options will suffice.

Meanwhile, officials must contend with the danger that the link between banks and governments that the banking union project aims to break may in fact be getting stronger. ECB data for August show that Italian banks are holding more of their own government’s debt than at any time since the debt crisis began.

The ECB and the EBA will need to decide how strongly to stress-test bank holdings of sovereign debt, even if current rules say they can hold those assets without any extra capital set aside for it. That decision will be key to the credibility of the whole exercise, said Martin Van Vliet, an economist at ING Bank in Amsterdam.

“If they don’t include a mark down for sovereign debt in the stress tests, everyone will say they are being too nice,” he said. “If they do include a big markdown, everyone will say that even the ECB thinks sovereign debt is unsustainable. They’re damned if they do, damned if they don’t.”

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