Auditor questions ECB’s framework for identifying failing banks

What is happening?

In January 2018, the European Court of Auditors (ECA) released a report that was full of praise for much of the work done by the European Central Bank (ECB) in terms of dealing with troubled banks. But it raised a number of concerns over the way the central bank designates a bank as failing or likely to fail, particularly in the early stages. This is managed via the Single Supervisory Mechanism (SSM) led by the ECB, and includes member state competent authorities.

Among the criticisms were that the ECB failed to disclose all the relevant information requested by the auditors, which they said hindered their work. For example, this apparently made it difficult for the ECA to judge the ECB’s effectiveness.

Other deficiencies the ECA highlighted included limited availability of onsite inspection teams to quickly gather information on the asset quality of a troubled bank, insufficient guidance around the ECB’s decision making, and a restrictive information flow between the ECB and the Single Resolution Board (SRB), which takes over the reins once a bank has been identified as failing.

Why is it happening?

The Luxembourg-based ECA is the EU’s independent external auditor. Its mandate is to ensure that EU taxpayers’ interests are protected, and to enhance transparency. Though it mainly focuses on the European Commission, it also audits other EU institutions.

For example, it is now onto its second audit of the ECB. In its first report published in November 2016, the ECA was concerned over potential conflicts of interest between the ECB’s roles of bank supervision and setting monetary policy, and believed it relied too much on staff from national supervisors.

Regarding the latter point, some industry sources believe that this is still the case, the fear being that national interests could undermine the ECB’s objectivity. In the ECB’s defence, it must navigate delicate national interests and the SSM relies heavily on national supervisors, and member states agreeing to that set-up.

The ECA does not have any legal powers, so cannot force change. However, it does make recommendations to the European Commission and EU member states.

Its power therefore is more one of moral suasion. If glaring inefficiencies are unearthed, the European Commission or member states could be prompted to take action.

What do the bankers say?

Banks are relatively ambivalent about the ECA’s reports, but do identify with some of its concerns. For example, there is a feeling that the guidance around the metrics and numbers that qualify a bank as ‘failing’ lack clarity and detail.

There could, of course, be a very good reason for that ambiguity. Quite possibly the ECB does not want to restrict itself to a fixed set of metrics, automatically forcing it to take action under certain circumstances.

Apart from undermining the ECB/SSM’s freedom of action, it could also spur a bank heading in the direction of a prescribed set of metrics to fail even faster as worried counterparties, investors and depositors run for the hills. It is a question of finding the right balance, which is extremely difficult. 

Will it provide the incentives?  

The ECA report, which is publicly available, did indeed draw responses from the ECB, also noted in the auditors’ verdict. The ECB challenged many of the auditors’ assumptions, such as those around insufficient human resources for assessments and its alleged lack of co-operation and transparency.

Where information was not shared, this was in the interests of confidentiality and commercial sensitivity, and the ECB feels it provided more than enough detail for the ECA to make an informed judgement.

But the ECB went on to say that it had already improved its guidance in September 2017, before the report was even released (the audit was carried out in June 2017).  

The auditors’ concerns are to a large extent technical, and though many in the industry consider some of them to be valid, there are bigger concerns with the bank resolution and recovery directive, which sets out the role of actors such as the ECB and the SRB and the single resolution mechanism.  

The biggest of these is whether or not the directive really addresses the too-big-to-fail problem and takes taxpayers out of the bailout loop. Politically speaking, bank bailouts remain a highly charged topic. Industry experts, including the credit rating agencies, still have some doubt over whether a large eurozone state would allow one of its largest banks (read, national champions) to be designated as failing by the ECB and then placed into resolution by pan-EU/eurozone regulators.

But it is also worth noting that these frameworks are still new, relatively untested and in need of refinement.