The European Central Bank has said its bank asset quality review (AQR) will treat all loans with arrears of more than 90 days as non-performing, whether or not the loan is recognised as defaulted or impaired. 

The AQR - which precedes a stress test of the 128 most important European banking groups - is being finalised this month.

A selection of portfolios for the AQR is due by the middle of this month.  

The ECB warned that as the stress tests incorporate capital requirements that may arise from the AQR, the end result "will be more demanding than in previous exercises".

Once this has been done, national bank regulators and their external specialists (auditors, consultants, asset evaluators) will review banks' processes, policies and accounting practices, analyse their credit exposures and provisions and evaluate their collateral and property assets.

The ECB will use the stress test parameters announced last Friday by the European Banking Authority - 8% Core Tier One equity in the baseline scenario and 5.5% minimum in the stress case scenario. 

Banks that do not meet the capital requirement in the baseline test will be required to urgently raise the extra capital required, while banks that miss the stress case target will be given a longer period to bring their capital up to the required level.

Sovereign bonds held by banks in their held-to-maturity portfolios will be treated in the same way as other credit exposures - that is, they will not be treated as risk-free, and will be subject to the same loss and default parameters as other investments. This is likely to result in larger provisions at the banks. 

Sovereign bonds held in trading and available for sale portfolios will be valued at market prices.  Bank holdings of sovereign bonds and their maturities will be disclosed in full.

The ECB has also identified a number of banks with what it described as "material trading book exposures" that will be subject to a specifically tailored AQR of the trading book. 

The banks - in eight of the 18 Euro area states - are some of the very biggest banking companies, such as Deutsch Bank, Societe General, Unicredit, Santander and BBVA.  The only Irish bank to undergo this special AQR is Merrill Lynch International Bank Ltd.

Although the bulk of the work in the AQR and Stress Test will be carried out by national regulators and their contractors, the ECB will deploy its own teams to oversee and participate in local bank inspections.

The stress test will assume a static balance sheet (for simplicity and ease of comparison).  The static balance sheet assumption may be set aside in cases where mandatory restructuring plans have been announced prior to end of December last year and formally agreed with the European Commission.  

The ECB expects to send the scenarios for the stress tests to banks at the end of April.  The scenarios will apply to balance sheets as they stood at the end of December 2013, and stretch over a three year period.