The European Central Bank may use its regulatory clout to make sure euro-area lenders are adding the right kind of capital, not just the right amount.
Policy makers say banks have added almost 200 billion euros ($258 billion) of additional capital since mid-2013 to boost their resilience. Yet only about a quarter of that sum is pure equity, as banks stock up on hybrid debt and tax arrangements whose loss absorbency is largely untested.
The ECB is wrapping up a year-long probe into asset valuations and capital levels at 131 of the region’s biggest banks as it prepares to assume its new role as the euro area’s bank supervisor on Nov. 4. Officials are already signaling they’ll take a tougher stance on lenders’ ability to withstand future losses.
“We need at some point to say, it’s not about nominal capital numbers, it’s about quality,” Elke Koenig, president of Germany’s bank regulator, Bafin and a member of the new ECB Supervisory Board, said in an interview in Milan. “We really have to differentiate. I’m pretty sure that one of the topics on the list of the SSM is the question about quality of capital.”
The ECB’s Comprehensive Assessment sets a benchmark for capital adequacy measured in the new global standard, common equity Tier 1, which is essentially equity plus retained profits. That kind of capital is immediately on hand should losses roll in. Lenders have to prove they can maintain a ratio of CET1 to risk-weighted assets of 8 percent under current conditions, and 5.5 percent under a simulated slump.
Vice President Vitor Constancio said this month that the ECB’s test is already a “big success,” since banks have bolstered their balance sheets to the tune of 197 billion euros since June 2013. Yet that total contains only 49.9 billion euros of fresh equity, according to data provided by the ECB.
The remainder includes one-off provisions, capital gains from asset sales and instruments less obviously able to withstand a downturn, such as deferred tax assets, which arise when a bank books losses or credits that it expects to be able to use to reduce its future tax obligations.
The U.S. “learned the hard way” about counting deferred tax assets as capital, said Karen Shaw Petrou, managing partner of research firm Federal Financial Analytics Inc. in Washington.
“The less a source of regulatory capital can be quickly monetized, the less value it has a source of strength,” she said. “Allowing instruments other than common equity to serve as capital makes the rules more complex and opaque, further undermining the framework’s overall resilience.”
Even when governments allow banks to convert deferred tax assets into credits that can be counted as high-quality capital, as Spain, Italy and Portugal have done, the ECB has said the practice may reduce the “incentive and/or the regulatory need for shareholders to inject fresh capital into credit institutions.”
Even though such assets represent a legitimate claim on the state, counting them as capital is messy, according to Bridget Gandy, managing director for financial institutions at Fitch Ratings in London.
“I just can’t see how regulators would want to include DTAs as something with loss-absorbing capacity,” Gandy said. “The deduction is being phased in, but each country is phasing in different elements of CRD IV at a different pace. I guess we’ll know this time next year what the ECB intends to do in this area.”
Beyond the horizon of this year’s ECB health check, with results due in the second half of October, banks are looking ahead to other regulatory demands, such as the requirement that lenders be able to show from next year that they can meet a rule to limit the level of debt versus equity, known as the leverage ratio.
European banks will issue about 20 billion euros more of contingent capital instruments, or CoCos, this year that count towards their additional Tier 1 requirements under global Basel III rules, according to an estimate by UBS AG. While those issuances may be able to help them meet the leverage rule, regulators and investors are becoming more skeptical.
EU oversight bodies including the European Banking Authority “are concerned about the practices used by some financial institutions to comply with enhanced prudential requirements” under a range of new EU rules adopted in response to the 2008 financial crisis, according to a statement. “Selling practices used in connection with such capital raising may put investors, depositors and policyholders at risk.”
Allowing banks to use debt instruments to meet capital rules is an area that regulators will need to look at, according to Gregory Turnbull Schwartz, a fund manager at Kames Capital Plc in Edinburgh, which has about 52 billion pounds of assets including bank bonds under management.
“If a bank were to exercise some of the options they have, under additional Tier 1s, then the market would quite quickly stop funding the bank, which would put it in quite a precarious situation,” he said. “We think that these instruments are not particularly robust.”