ECB vies for third time lucky in European stress tests

For the European Central Bank, success as the euro area’s financial supervisor may begin this weekend with a few failures.

At noon in Frankfurt on October 26, investors will learn which of the currency bloc’s 130 biggest banks fell short in the ECB’s year-long examination of their asset strength and ability to withstand economic turbulence. After two previous stress tests run by the European Banking Authority didn’t reveal problems at lenders that later failed, the ECB has staked its reputation on getting this exercise right.

The two-part audit known as the Comprehensive Assessment forms one pillar of the ECB’s effort to move the euro zone forward after half a decade of financial turmoil by disclosing the extent of the damage. Since the beginning, ECB President Mario Draghi has said banks need to fail to prove the losses of the past have been dealt with.

“There will be enough for policy makers to declare victory, but the full picture will take longer to emerge because this thing is so complicated,” said Nicolas Veron, a fellow at the Bruegel research group in Brussels. “What you don’t want is to sound the all clear and then three to six months later, there’s an unpleasant surprise.”

Bank-level data and an aggregate report on the Asset-Quality Review and stress test will be released on the ECB’s website at 12 p.m. Frankfurt time. The ECB stress test was conducted in tandem with the London-based EBA, which will release its results at the same time. The EBA’s sample largely overlaps the ECB’s, though it also contains banks from outside the euro area.

Bond-Market Collapse

ECB Vice President Vitor Constancio and Supervisory Board chair Daniele Nouy will hold a press conference to explain the results 30 minutes later.

Some banks are already said to have failed, such as Permanent TSB Group Holdings Plc, Ireland’s smallest state-owned bank, which fell short in the ECB’s adverse stress test, a gauge of resilience over three years after a hypothetical recession and bond-market collapse. Permanent TSB, based in Dublin, passed the other two elements of the assessment, according to a person with knowledge of the matter.

Banca Monte dei Paschi di Siena SpA and Banca Carige SpA, two of 15 Italian lenders in the health check, are set to face capital shortfalls they’ll need to repair, according to a person with knowledge of the matter.

Eligible Capital

Royal Bank of Scotland Group Plc analysts led by Alberto Gallo say mid-tier Italian, Cypriot, Portuguese and German names are at risk of failing the assessment, with the net capital shortfall of the entire system estimated at 10.2 billion euros. ($12.9 billion)

To pass the Asset-Quality Review, which scrutinizes the asset side of balance sheets as of December 31 last year, banks need common equity Tier 1 capital equivalent to at least 8 percent of risk-weighted assets. In the adverse stress test, the pass mark is 5.5 percent.

In practice, not all failures will be equal. As the exercise was based on balance sheets as of year-end 2013, some capital shortfalls have already been addressed in the meantime. The ECB will note eligible capital raised in the year to September 30 as part of each bank’s results.

That cut-off creates a class of as many as 19 “technical failures,” according to Gildas Surry and Geoffroy De Pellegars, analysts at BNP Paribas in London. These include seven Italian banks, four Greeks and one each in Spain and Portugal, countries that were worst affected by the debt crisis.

Deutsche’s Fitschen

Deutsche Bank AG, Germany’s largest lender, is also at risk of being a technical failure, though it raised 8.5 billion euros in fresh equity in the second quarter, according to analysts at Bankhaus Lampe and Bankhaus Metzler.

German banks will need to address their weaknesses even if most of them pass the Comprehensive Assessment, said Juergen Fitschen, co-chief executive officer of Deutsche Bank.

“If you listen to the news on Sunday and hear, as will probably happen, that all German banks have survived the stress test, with the exception of some smaller banks mainly in the southern region, don’t then assume that everything is fine,” Fitschen, who is also president of the BdB Association of German Banks, said on Thursday.

Policy makers are signaling that a smaller category of banks already in the process of restructuring or wind-down will display capital gaps not yet filled, and be among the outright failures. The Austrian government said on October 17 that it was optimistic about talks to address shortfalls at Oesterreichische Volksbanken AG.

‘Game Changer’

“Not that many will fail outright,” said Nicolas Doisy, senior economist at Amundi, the asset management arm of Credit Agricole SA. “The Comprehensive Assessment will be a game changer, but it won’t play out in one go.”

The impact of the ECB’s assessment on capital ratios, and its push for banks to raise their provisions against future losses, will probably become evident in year-end financial statements published in early 2015. The ECB will publish its own estimate of eligible bank capital-raising measures taken since January 1, which compared with the capital gap will give some indication of what still needs to be done. The ECB is leaving it up to lenders themselves to make public what their new up-to-date CET1 ratios are.

If lenders need to raise capital, they have until November 10 to produce a plan, and as much as nine months to raise the cash, according to ECB rules.

Health Check

The ECB says that lenders have strengthened their balance sheets by almost 203 billion euros, partly under the pressure of the Comprehensive Assessment. Yet less than a third of that figure is common equity, the highest-quality form of capital, and policy makers have signaled this headline number doesn’t quell all doubts.

The ECB has poured resources into the health check and pushed national regulators and banks to take a more conservative view of their books than before. The mere occasion of the review has caused balance-sheet boosting measures that wouldn’t otherwise have happened, according to Philippe Bodereau, London-based head of financial research at Pacific Investment Management Co. In that context, a relatively small number of failures in the test may not matter.

“We are getting to a point of the banking cycle where a vast majority of legacy losses have been recognized,” Bodereau said. “The AQR will, in our view, efficiently identify the remaining areas of weakness. Six years after the collapse of Lehman Brothers, two and a half years after Greece’s debt restructuring and following intense deleveraging and balance sheet shrinkage, Western banks are just running out of ways to lose money.”

[Bloomberg]