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WorldOctober 1 2014

Why Europe needs a Comprehensive Assessment

The European – and indeed global – economy is facing a crucial six months. Central to this is the European Central Bank's Comprehensive Assessment, which will go a long way to boosting confidence within the EU.
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Why Europe needs a Comprehensive Assessment

The next six months are crucial for the world’s financial wellbeing. Much depends on what is done in Europe, the global growth laggard. Will the European Central Bank (ECB) introduce quantitative easing? Will eurozone governments commit to bold reforms? Will the euro become more competitive? Bulls and bears are placing their bets.

Fortunately, there is one European exercise that is certain to boost confidence and contribute to economic recovery: the ECB’s Comprehensive Assessment (CA). This is good news for Europe and, frankly, for the global economy. 

One-two punch

The CA – consisting primarily of the asset quality review and the stress test – is a process aimed at bringing greater transparency to bank balance sheets and ensuring consistent regulatory oversight in Europe. The assessment will provide bank-specific data and recommendations. Similar one-two punch processes were used successfully in Ireland, Spain and Slovenia recently.

The CA is demanding in every sense. As the ECB prepares to replace individual national regulators in supervising Europe’s main banks, it has pored over the books of the eurozone’s 127 biggest banking groups, which represent some 85% of the region’s banking assets. The cost in terms of time and money has been high.

The CA results will be announced in the coming weeks. I expect most banks to pass the assessment, although many will face a competitive disadvantage as investors are able to make apples-to-apples comparisons of capital adequacy across peers.

Other institutions will have their capital shortfall revealed. These banks will have two weeks to submit their capital plans to address their balance sheet weakness. Undercapitalised but viable banks will then have six to nine months to strengthen their buffers by turning to private money from the market. We will likely see strong banks absorbing weak banks.

Reputation at stake

The CA results need to be tough and credible. The fact that previous stress tests failed to identify systemic problems means the ECB’s reputation is at stake. But that is the least of its concerns. No one, anywhere, can afford there to be doubts about the results – or consequences.

An honest and demanding CA will boost trust in Europe’s regulators and its banks. This in turn will strengthen confidence in the region's financial system. Trust in our banks means a greater ability to extend credit to families and businesses. CA is all about the real economy.

Overall, the banking sector has become significantly safer in recent years. The International Monetary Fund reports that European banks now hold three times more of the safest form of capital than before the crisis and have reduced exposures to riskier trading assets. But the recent failure of Portugal's Banco Espírito Santo shows that more is needed. I think the CA fills the gap.

Some banks have moved to strengthen their capital base even before the CA results are out. In this sense, the assessment is already making the European banking system more stable and robust.

The CA will give an immediate reading on who is strong and who is weak. But just as important, it will harmonise the way collateral and non-performing loans are defined across countries. This means investors and regulators will know which banks are within the rules but have been playing them loosely. The immediate results will be increased loan loss provisions for many banks.

Intesa’s lead

I am certain that my own institution – Italy’s Intesa Sanpaolo – will be a clear winner in the CA. We are already the strongest bank in the eurozone in terms of capital and liquidity. Our capital ratio on a fully loaded basis is 12.9%, by far one of the highest among major European banks. At the end of June, our excess capital was approximately €10bn and we had a capital buffer of approximately €13bn ahead of the asset quality review and €20bn ahead of the stress test. The bank boasts a significant extra liquidity buffer in terms of our fully loaded net stable funding ratio at 100%.

For us, the CA is a welcome opportunity to reap the fruits of our labour. We plan to return cash to our shareholders once we have our CA results and all regulations on bank capital requirements have been set by regulators. 

I think our Italian peers will also manage to face the assessment successfully with no major capital shortfalls. Italy’s banks have raised €40bn since the beginning of the crisis – of which €11bn came just this year – and the markets have reacted supportively. The greater concern remains the need to drive essential structural reforms and gain the flexibility to move from austerity to stimulus. I'm confident that the current government has the talent and the support to do this.

The outcome of the CA will be to show which banks are healthy, which need a boost and which are a risk to the system. Those that show balance sheet weakness will have ample opportunity to strengthen their position by turning to the market in the months following the assessment. And those banks that can’t stand on their own will need to merge with stronger banks.

No future for some

It is encouraging that the ECB [chair of the supervisory board of the single supervisory mechanism] Danièle Nouy has acknowledged that some banks have no future. She has said that closure, not merger, will be the remedy in some cases. I hope that this is applied in practice should the CA reveal the need. The so-called zombie banks tend to apply loose credit and pricing standards, relying heavily on central bank money and forms of state support – this results in unfair competition that undermines the banking system.

Real results will produce real trust. We cannot budge from this. Ultimately, an honest stratification of strength and risk will lead to real-economy benefits. It will enable banks to be banks, financing the lives and livelihoods of our citizens. Today, asset quality uncertainty weighs on banks’ ability to lend. Loan conditions and loan demand have improved this year, but lending remains tight.

The CA exercise is a real and positive boost to Europe’s financial health. But there are, needless to say, limits to what CA can achieve. Failure to reform by eurozone member states can easily derail the process. Attention has been on the southern peripheral states – where problems persist – but more attention and pressure needs to be placed on those core countries that are also failing to reform. Just as importantly, we cannot have some eurozone states continuously running surplus positions that are not sustainable for the rest of their economic partners, otherwise the European recovery that the ECB is trying to create will fail.

Need for reform

In my home country of Italy, there is a burning need for substantive reforms. The political willingness is there but the pace of improvement needs to catch up with the social and economic realities. The most vital ingredient – political stability – is also there. But this needs to be paired with structural reforms that create a virtuous cycle that benefits employment, consumption and production.

Investments are key. The CA should lead to improved lending across the industry. Our bank has already committed to €170bn in medium- and long-term new lending to the Italian economy. And there is a need to encourage companies to turn to instruments such as mini bonds.

Last month, the ECB surprised markets by cutting its rates to near zero. The euro immediately lost value, a move that is likely to benefit the eurozone's exporting nations. The rate cuts should also encourage take up of targeted longer term refinancing operation (TLTRO) funding by eurozone banks. Ultimately, the rate cut – together with the planned purchase of asset-backed securities, a third covered bond purchase programme and cheap TLTRO liquidity – should direct cash into the real economy and spur growth. 

There is not much else the ECB can do to make a big impact – short of a last-resort purchase of government bonds on a large scale. So the real responsibility for growth shifts back to EU member state governments. They need to continue on the path of fiscal consolidation and structural reforms. 

ECB president Mario Draghi has made it clear that this is what he expects. In his September speech he warned that insufficient structural reforms are a real downside risk for the eurozone economic outlook. The worst that could happen is that the benefits of the ECB's moves take enough pressure off of governments that they once again become complacent. 

Reforms must go forward. Generations of Europeans cannot afford anything less.

Carlo Messina is the chief executive of Intesa Sanpaolo. 

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