ECB details criteria for upcoming bank tests

Tuesday 11 March 2014 18.10
Estimates of the capital shortfall ion euro zone banks range from €280 billion to as much as €770 billion
Estimates of the capital shortfall ion euro zone banks range from €280 billion to as much as €770 billion

The European Central Bank will press banks to revalue their assets and take a more realistic view on likely losses when it probes their balance sheets in coming months.

The move signals a new, more aggressive era of banking supervision in the bloc.

Publishing guidelines for its forthcoming asset quality review, the ECB said it would trawl through trillions of euros of assets at 128 leading banks between now and August, aiming to ferret out any problems before it takes over as the euro zone's banking watchdog in November.

The exercise is part of a bigger plan to harmonise the way banks are supervised and if necessary wound down, aiming to restore the sector's stability and avert a repeat of the debt crisis which cost trillions in taxpayer bailouts.

While preparations for coordinated supervision are already in full swing, European ministers were still trying to agree on how to build a safety net for failing banks in Brussels, redoubling efforts to avoid an embarrassing delay to the euro zone's centrepiece crisis reform.

Sabine Lautenschlaeger, vice chair of the banking watchdog and a member of the ECB's executive board, told the Wall Street Journal she expected some banks would need to improve their capital situation as a result of the tests, either by raising funds or selling assets, without giving a specific number. "It's the last chance to clean up," she was quoted saying.

The asset quality review will be followed by "stress tests" to see how banks would fare under certain shock scenarios. All results will be released in October.

Estimates of banks' capital shortfall range from €280 billion to as much as €770 billion.

Previous stress tests of leading EU banks failed to completely root out problems in the sector and the scope of the current review that combines backward looking checks and forward looking stress scenarios is unprecedented.

Euro zone banks have never before been measured against common thresholds, such as a single definition of when loans become impaired, and many have never had their books interrogated in such detail. Previous tests relied on locally approved data.

"We expect the AQR and stress test to introduce greater transparency on 'problem assets' and speed up the healing process," said analysts at Citi.

Many banks have already been raising funds, shedding assets and writing off bad debts ahead of the review and stress tests. 

Italy's Unicredit for instance has posted a shock €14 billion loss after writedowns on goodwill and bad loans, as it moved to clean up its balance sheet ahead of the ECB's health check.

Once the results are known, the ECB will push banks to reflect some of the findings in their 2014 accounts.

Banks will only be expected to change their 2013 accounts in the unlikely event that the review highlights issues that should lead to a restatement according to local law, it said.

The ECB's guidelines also set out different scenarios when loans should be classified as impaired. 

For example when a debtor has requested emergency funding from a bank, or if a company that has taken a loan gets into financial difficulty and experiences a material decrease in turnover or the loss of a major customer.

As part of the exercise, the teams will also check whether collateral, for example in the form of real estate, aircraft, ships or artwork, is correctly valued, with help from external experts or by updating recent independent market valuations.

Collateral that has not been valued in the previous 12 months will have to be re-evaluated.

Collateral valuations are one of the biggest sources of uncertainty for banks in Italy. 

Sources told Reuters on Friday that the Bank of Italy was hiring up to five real estate consultants to assess whether banks are correctly valuing property used as loan collateral.

Beyond loans, "level 3 assets" - a broad group of assets that are difficult to value - will also be assessed. These include derivatives, assets such as real estate holdings which banks have acquired through foreclosures, participation in private equity deals and special investment vehicles.

The ECB will run a more in-depth review of such assets at 29 banks with material exposures, which include Deutsche Bank , Commerzbank, Societe Generale, UniCredit and Santander.

"It is expected that, in most cases, fewer than 10 derivative pricing models will be reviewed for each bank included in the trading book review, depending on the size of the bank's exposure to level 3 derivatives," the manual said.

Some banks included in the trading book review will have no relevant level 3 derivative pricing models to review, it added.