There were few surprises in the outcome of the European Central Bank’s asset quality review and stress test, but the results highlight what still needs to be done.

The European Central Bank’s (ECB) comprehensive assessment, composed of an asset quality review (AQR) followed by a stress test, disclosed shortfalls of €24.6bn in eurozone bank capital based on end-2013 results, of which €18.6bn has already been covered by capital actions taken during 2014. Italian banks had the largest gap to fill, with four failing the test and Monte dei Paschi showing the heaviest single shortfall at €2.1bn even after capital-raising measures in 2014.

The challenge for the banks that failed will be to prove to investors that they have a viable business model worthy of fresh capital commitment. And for all eurozone banks, the advent of a single supervisory mechanism (SSM) housed in the ECB in Frankfurt could bring profound changes to their relationship with their supervisors, which will alter the way the banks are managed. The SSM assumed full control of eurozone banking supervision from November 4, 2014.

The SSM has compiled a supervisory manual thought to run to about 1000 pages, which it hopes to disclose publicly at least in part in 2015 as practices become established. The 120 most significant banks in the eurozone, covering about 80% of total assets, are being supervised directly by SSM teams that will include a coordinator and a mix of supervisors from a bank's home country and from its peers. A long tail of several thousand smaller banks will be supervised indirectly via the national competent authorities (NCAs).

“The single supervisor and its manual may take elements of what has been done in each country, but as a whole it will be different from supervision in any individual country; it is going to be a new system. That change is not going to be radical from November 4, it will take time for all the nuts and bolts to be operating normally,” says José María Roldán, the president of the Spanish Banking Association and former head of bank supervision at the Banco de España.

Scrutiny for supervisors

The SSM will not just mean a new player examining the banks. The NCAs are also under scrutiny, especially in countries where the AQR process exposed significant differences in practices for reporting non-performing exposures (NPEs). The introduction of a common definition for NPEs as part of the AQR is widely considered as one of the single most valuable contributions of the entire comprehensive assessment.

“The harmonisation of the NPE definition was crucial to ensure a consistent treatment of debtors being reviewed and allowed [us] to set a level baseline, against which debtors could be assessed. As a result of this harmonisation, and because banks’ internal definitions were generally less conservative than the definition used by the AQR, €55bn of additional NPEs were identified at the outset of the credit file review,” Danièle Nouy, the founding chair of the SSM, told the press conference announcing the results of the comprehensive assessment.

In total, €136bn was added to NPEs for the eurozone banks covered, resulting in a reduction of €48bn in capital levels even before the stress scenarios were applied. In Slovenia, 32% of loans in the AQR sample were reclassified to NPEs, but the country is still in the midst of a banking crisis and restructuring process. More worrying were the 21% increase in Greece and 14% increase in Cyprus, both of which have been through domestic AQRs already. This resulted in a 220-basis-point (bp) reduction in capital in Cyprus due to the AQR and 290 bps in Greece.

“There are differences of methodology, but it does raise some questions about the credibility of previous AQR exercises in Greece and Cyprus. The ECB stress test exercise was also more comprehensive – the prior exercises for the Greek banks only included credit stress, whereas the ECB stressed sovereigns, securitisations, profit and loss,” says Fernando de la Mora, a managing director at consultant Alvarez & Marsal in Madrid who previously advised US banks on the Federal Reserve’s stress tests.

Patterns of behaviour

Panicos Demetriades, a professor of financial economics at Leicester University in the UK, who steered the Cypriot banking sector through a domestic AQR and stress test as central bank governor in 2012, is confident that the publication of so much data has already helped to bring to light “some interesting patterns of past behaviour” that may reflect “variable practices” by national supervisors across the eurozone. He expects the advent of the SSM to put an end to such variability and pave the way for a level playing field in terms of supervisory practices.

“There is no doubt that the establishment of the SSM will change the relationship between national supervisors and national banking systems, since supervisory powers are being transferred to the ECB. This will certainly help to contain supervisory capture at the national level, where big banks are sometimes able to exploit their considerable economic weight to influence supervisory decisions,” he says.

Conversely, he is concerned about the drain on national supervision agencies from staff transferring to the SSM. This is happening at precisely the point when the workload of NCAs is increasing, as they will need to devote resources to participating in the examination of banks in other SSM countries, and supporting their appointed SSM board member.

“Both the ECB and national supervisors need to attract new staff, and to retain and develop existing human capital in the area of banking supervision, and they need to do so at a much faster pace than is normally the case. This will, of course, be a socially beneficial investment, but like many other investments whose social benefits exceed the private costs, the outcome is likely to be sub-optimal,” says Mr Demetriades. 

Sense of proportionality

Not everyone is overjoyed at the prospect of power shifting away from national supervisors to the ECB. This is especially true for the smaller banks that will be indirectly supervised. Gerhard Hofmann is a board member of the German co-operative banks’ association BVR and a former bank supervisor at Deutsche Bundesbank. The BVR represents two apex banks, DZ and WGZ, that will be directly supervised, but also more than 1000 Raiffeisenbanken and volksbanken, which will be supervised through the NCA.

Mr Hofmann says the balance between the ECB and national supervisors will remain an ongoing source of uncertainty. He expects the ECB will be reluctant to allow the development of a sharply divided two-tier system between the directly and indirectly supervised banks, but national supervisors will also push back to preserve national specificities where they are valuable. One practical and very controversial area will be on the matter of whether banks adopt international financial reporting standards (IFRS) for their accounts.

“In the medium term, there will be pressure for the ECB to move the 120 significant banks to IFRS to build a homogenous database for regular reporting. But does that mean all the 3600 smaller banks must also make the transition or will there be proportionality? The ECB is not the accounting standard-setter, and it should not go beyond its competencies without a full and open discussion about a new directive,” says Mr Hofmann.

Speaking at the London School of Economics in November 2014, SSM board member Ignazio Angeloni took a firm line on the question of smaller banks, emphasising that the separation between direct and indirect supervision was a “practical” decision that was not intended to carry deeper implications. “We have both the will and indeed the duty to push for a level playing field for all banks in the eurozone, not just the directly supervised ones. And we retain the power to bring some indirectly supervised banks under direct supervision if we think it is necessary, even if they do not meet the size criteria,” Mr Angeloni said.

Mr Roldán is supportive of the ECB exerting its authority. After rounds of domestic asset quality reviews, Spanish banks came through the ECB’s AQR with one of the smallest adjustments to existing NPE rates. Mr Roldán says the Spanish central bank had always considered itself as not just a prudential regulator, but an accounting regulator as well.

“The AQR suggested that, although most banks’ provisioning practices are based on IFRS, there were significant national specificities. The ECB is not the accounting regulator, but this is an area that may need to be examined by the ECB, it is an important question they will need to answer in the coming years,” he says.

Level playing field

Mr Roldán adds to that the need for consistency in the approach to modelling risk-weighted assets (RWAs) across the eurozone, to make capital ratios homogenous and comparable. Moreover, the ECB will need to make sure that each of its multinational supervisory teams retains a common approach so that supervisory practices in each country do not evolve with too many differences.

The question of RWA variation has now been taken up by the global Basel Committee on Banking Supervision, which published a paper in November 2014 outlining a number of policy initiatives to ensure that bank capital ratios are comparable. The ECB may want to await the outcome of that review, but there is growing pressure for it to tackle RWA variation within the eurozone to meet its commitment to a level playing field. For Paulina Przewoska, a former bank supervisor at the Polish Financial Supervision Authority who is now a senior policy analyst for public interest advocacy group Finance Watch, the reliance on banks’ internal models was a key weakness of the comprehensive assessment.

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“Some of the AQR findings may have led to adjustments in the RWA calculated with internal models, for example, if findings showed that the historical data such as default rates used for internal models was not correct. If material, this new information should have been included in the joining-up process [between the AQR and stress test]. But basically the AQR and stress tests were not designed to verify or validate the models, which the ECB plans to do when conducting pillar-two reviews as a supervisor,” says Ms Przewoska.

Mergers ahead?

Speaking at a press conference to announce the comprehensive assessment results, ECB vice-president Vítor Constâncio estimated that eurozone banks had raised €60bn of equity capital and €32bn of additional Tier 1 capital such as contingent convertibles since July 2013. Compared with this, the €9.5bn residual shortfall looks digestible on aggregate.

Individual banks, however, will be judged on their own strengths and weaknesses – and the latter will surely be the focus for those that failed the test. There are profound questions over the future of Monte dei Paschi and the popolare (co-operative) sector in Italy – the other three Italian banks that need to raise capital were all from this segment.

Prolonged recession has hurt the asset quality of their primarily small business loan portfolio, and weak demand for fresh loans further impedes profitability. Pietro Reichlin, a professor of economics at Luiss Guido Carli university in Rome and member of an advisory committee to Gruppo Banco Popolare (which passed the comprehensive assessment thanks to a pre-emptive capital raising), says he expects deeper restructuring and consolidation in the Italian banking sector.

“There are a fair amount of smaller popolare that have a limited range in terms of activities, which is not good in this period, but the situation is not as bad as it was for the Spanish cajas, because there has not been the same sharp fall in property prices,” says Mr Reichlin.

In the past, dominant ownership by local fondazione (investment foundations) made it difficult to negotiate mergers between Italian banks. But Mr Reichlin says this structure is changing, with Monte dei Paschi at the forefront of that trend because the fondazione was held responsible for some of the bank’s disastrous strategic decisions. “The situation is improving in terms of governance, and the possibility of restructuring the Italian banking sector is growing,” he says.

Even after the wave of distressed consolidations among Spanish cajas, Mr Roldán says the process may not be complete. At least in theory, the advent of banking union is intended to bring about a genuine eurozone single market for the sector.

“It remains to be seen if there will be mergers. In theory the banking union should make more pan-European combinations possible. But what is certain is that it will take as long as a decade to recover from the fragmentation of the banking system that happened during the eurozone crisis, the renationalisation of financial flows was fierce. We must hope that the SSM will help to reverse that renationalisation and prevent it from happening next time,” says Mr Roldán.


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