Crunch time for European banking

As European regulators approach the final stages of their efforts to restore credibility to the region’s banking sector, we look at the implications for credit markets and European bank lending.

In what will be one of the biggest advances in European integration since the launch of the Euro in 1999, from November 2014 the European Central Bank (ECB) will assume the role of Single Supervisor for Europe’s largest banks.  Before then it will reveal the results of a robust asset quality review (AQR), and stress test exercise which will be crucial to restoring confidence in the European banking sector.

Cross-border banking integration and stronger supervision are expected to reduce the financial fragmentation which has contributed to the European Crisis and stunted Europe’s recovery.

The comprehensive assessment (Figure 1) is designed to provide transparency, re-build capital and build confidence in Pan-European banks, reducing dependency on the ECB for lending. Much is resting on the AQR. Initial stress tests in 2010 and 2011 failed to fully restore confidence in the European financial system.

However, despite concerns surrounding the execution of previous exercises, the ECB’s three-stage probe is expected to be more successful in cleaning up the European banking system. It consists of an initial supervisory risk assessment to identify portfolios that need scrutiny; an ongoing AQR, which will ensure bank assets are valued the same way in every European country; and the concluding stress tests, which provide a more complete picture of European banks’ capital adequacy than previous tests.

Overall 130 banks, which together hold 85 per cent of system assets, have come under scrutiny, with strong ECB oversight to ensure consistency, independent audit at all levels and a uniform reporting template to ensure transparency. Banks are expected to be notified of the results around 17 October and a public announcement is currently expected to be made on or around 28 October regarding the outcome of the common exercise.

The road to transparency

One of most important aspects of the exercise will be the disclosure of comparable and consistent data and results across the EU.

The US Federal Reserve conducts a similar review on an annual basis, the Comprehensive Capital Analysis and Review (CCAR), now in its fourth year. The CCAR was credited with getting US banks lending to each other again following the Global Financial Crisis and it is hoped that the ECB’s latest attempt will provide a similar watershed for Europe

Under the current system in Europe, the ECB is still providing emergency credit due to the lack of trust between banks. Minimal transparency, language barriers and differing accounting rules have led to a widespread concern that some banks are undercapitalised and may be hiding bad assets.  As a result, peripheral banks in particular are struggling under the weight of higher funding costs if they can access the market at all.

The ECB is working closely with national regulators to align accounting standards, which were previously fragmented at best. Italian banks, for example have had a more conservative definition of non-performing loans leading to higher reported NPLs, while in Spain some repossessed real estate assets can be reclassified as performing assets.

Once the assets have been uniformly defined and valued they will be subject to two stress tests – baseline and distressed. Under the baseline scenario banks must achieve a minimum common equity tier 1 capital ratio of 8 per cent while under the more stressed scenario they must be above 5.5 per cent to pass.

The broadening of the ECB’s role is an important step toward a more workable European Union. The European Banking Association (EBA) will act as a data hub for information on the capital position of banks, risk exposures and sovereign holdings. Any European bank will be able to look up the relevant data for another bank and know how, under common criteria, it would perform under the stress test scenarios. This will help banks to decide whether to deal with another bank in the interbank lending system.

Strong capital levels should also help to ensure that banking organisations have the ability to lend to households and businesses and to continue to meet their obligations, even in times of financial difficulty.

Will banks pass the stress test?

Once the ECB’s results are disclosed, banks with a capital shortfall will have two weeks to come up with capital restoration plans. They will then have six months to cover any capital shortfall identified in the AQR under the baseline of the stress tests and nine months for those identified under the adverse scenario.

Banks are being strongly encouraged to use private capital to shore up their balance sheets and the price for using public support will be high. State aid rules implemented since last summer state very clearly that the use of public money will require burden sharing, with the bail-in of junior debt and hybrid capital instruments. These rules ensure that investors must be the first to pay for errors committed by banks, and taxpayers only as a last resort.

Since July 2013 banks have been strengthening their balance sheets through various measures. So far the ECB has noted in excess of €100 billion that has been raised, so the market expects that any further capital requirement should be manageable overall.

A recent Ernst & Young survey of European banks showed most are confident of the outcome, with only 8 per cent planning to raise capital after the AQR. German banks are the most confident, while Spanish banks are the least confident (Figure 2).

Source: Ernst & Young European Banking Barometer, H1 2014

The implications for credit markets

In our view, the review could highlight weaknesses in smaller regional banks, particularly those in Italy, Germany, Greece and Austria.

However in the longer term, investors should be more confident that European banks have been assessed on a level playing field, that there has been credible independent oversight of the process and that those banks that pass the test are resilient and well capitalised.

Overall the assessment is expected to contribute to a lower volatility environment, improving global credit market conditions and the outlook for SMEs.  Banks should see their funding costs come down and, having been given a clean bill of health, should be more willing to supply much needed credit to Europe’s struggling business sector. It is possible that the AQR will prove to be a crucial turning point on Europe’s long road to recovery.

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