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Europe Looks to the ECB to Restore Region's Banks to Health

With its comprehensive assessment, central bank aims to restore confidence in banks and get them lending again.

  • By Tom Buerkle

SPECULATION ABOUT A BREAKUP of the euro area was at a fever pitch in July 2012. Fears that the bloc’s debt crisis would infect Italy and Spain drove yield spreads on peripheral bonds to record levels, threatening to bankrupt those nations. German resistance to fresh bailouts risked undermining the group’s political cohesion. The stakes were incredibly high when Mario Draghi, president of the European Central Bank, appeared at a London investment conference and stated that the ECB was “ready to do whatever it takes to preserve the euro.” With that firm yet vague declaration of resolve, Draghi effectively stopped the rot and put the debt crisis on a manageable path.

Today all eyes again are on the ECB as it takes on one of its biggest challenges yet: supervising the largest banks in the 18-nation euro zone. The debt crisis may have eased, but the zone’s economy and banks remain deeply troubled. Economic output is recovering at a snail’s pace after a nearly two-year recession. The European Commission predicts growth of 1.1 percent this year, too sluggish to dent the euro area’s 12.2 percent unemployment rate. Weak banks have been deleveraging at a rapid clip, starving companies of the credit that could propel a vigorous rebound. And banks’ books remain loaded with government bonds, leaving the sector as vulnerable as ever to a revival of fears about sovereign creditworthiness.

In a bid to restore the banking sector and the economy to health, European Union leaders last year agreed to take control over banking supervision from national authorities in the euro area and hand it to the ECB — a key element of the bloc’s so-called banking union. Danièle Nouy, head of France’s Prudential Supervision and Resolution Authority, moved to Frankfurt last month to become the first chairman of the single supervisory mechanism (SSM), as the central bank’s new unit is plainly named (see “Europe's New Banking Supervisor Promises Transparency and Rigor”). She is gearing up for a two-part comprehensive assessment that aims to draw a line under the banking crisis. The exercise, which will begin sometime in February or March and run through October, will include an asset-quality review (AQR), designed to give a true and consistent picture of the health of bank balance sheets across the euro zone, and a stress test that will determine whether the banks need to raise fresh capital.

The stakes couldn’t be higher. Initial stress tests conducted by the London-based European Banking Authority in 2010 and 2011 were widely panned as failures by analysts and investors because they relied on national data of varying quality and omitted the banks’ massive sovereign bond holdings from the test. Within months of getting a passing grade from the EBA in 2011, Belgian-French bank Dexia and Spain’s Bankia effectively failed, requiring multibillion-euro bailouts from their governments and forcing Spain to seek assistance from the EU’s European Stability Mechanism (ESM).

European officials know the bloc can’t afford to flunk another test, and that is why they have handed the responsibility to the ECB — the one EU institution to emerge from the crisis with its credibility enhanced. “The comprehensive assessment of the banks must be a very rigorous exercise because the reputation of the ECB as a whole is at stake,” Vítor Constâncio, vice president of the central bank, tells Institutional Investor. “We cannot compromise that, and we will not.”

Market optimism has been building in recent months, reflecting confidence in the ECB’s new role as well as in moves by banks to bolster their capital strength. Bank stocks outperformed the European market in the second half of 2013 as investors bet that the tide had turned.

“I’m pretty convinced that there won’t be any surprises” in the ECB’s comprehensive assessment, says Stephen Macklow-Smith, a portfolio manager at J.P. Morgan Asset Management who runs the European assets of U.K. pension funds. “This has been coming at the banks ever since the financial crisis. There is a massive and very positive opportunity for the euro zone as a whole to clear things out for a proper capital market.”

Success is far from guaranteed, though. Consider the sheer management challenge facing Nouy and her team. They need to hire 1,000 staff, including 750 experienced banking supervisors, increasing the ECB’s payroll by nearly 60 percent; agree on the methodology of the stress tests, which will be conducted in conjunction with the EBA; and carry out a detailed review of the balance sheets of nearly 130 banks, which account for 85 percent of the assets of the euro area’s banking industry. By contrast, the U.S. stress tests of 2009 — an exercise that proved critical to America’s financial turnaround, which European officials hope to emulate — covered only 19 banks and were carried out by well-established supervisory teams at the Federal Reserve, the Federal Deposit Insurance Corp. and the Office of the Comptroller of the Currency.

“It’s going to be very complicated,” says David Green, a former senior supervisor at the Bank of England and the Financial Services Authority who currently works as a consultant and serves on the Independent Commission on the Future of the Cyprus Banking Sector. “Nobody’s done anything like this before.”

In addition, many observers worry that euro area governments are dragging their feet on the other two elements of the bloc’s banking union. In December, EU leaders endorsed a plan to create a single resolution mechanism (SRM) that would wind up failed banks and a single resolution fund to finance any such interventions. Together with the SSM, these new institutions are intended to give euro area governments the tools to tackle banking failures and break the link between indebted sovereigns and failing banks, which forced Cyprus, Greece, Ireland, Portugal and Spain to seek bailouts. But many experts doubt that the EU plan is adequate to the task.

The SRM, for instance, must go through an elaborate number of steps to resolve a failing bank. A resolution board comprising representatives of the ECB; the EU’s executive agency, the European Commission; and national governments must agree on the need to act, then obtain approval from the full Commission. If the Commission doesn’t approve, the issue gets kicked to the national governments. On paper the procedures represent an improvement over today’s ad hoc arrangements among national regulators. In practice, many experts doubt whether the mechanism can smoothly wind up a big cross-border bank over, say, a weekend. More likely, says one senior bank executive who spoke on condition of anonymity, is a repeat of the chaos surrounding Fortis when authorities in Belgium, France and the Netherlands scrambled to seize the banking and insurance group’s assets after its failure in 2008.

The proposed single resolution fund falls well short of being the financial bazooka that many EU officials, including those at the ECB, hoped to be able to wield in a crisis. The fund, financed by bank fees, will initially consist of national pools of money and slowly grow into a euro area pot of some €55 billion ($74.5 billion) after ten years. That number awes no one, considering that euro area governments have injected €275 billion into banks since the crisis. The ESM, the EU’s bailout fund, spent €41.3 billion in 2012 and 2013 just to recapitalize Spanish banks. “Ten years is far too long for a fund that really isn’t that big,” says Sharon Bowles, chairman of the European Parliament’s Economic and Monetary Affairs Committee.

The Parliament must give its approval to the SRM and resolution funding, and members are threatening to block a deal unless national governments agree to make the procedures more communal in nature and less dependent on domestic politics in the member states. “We can’t accept a mediocre solution for the single resolution mechanism,” says Elisa Ferreira, a Portuguese Socialist who represents the Parliament in negotiations over the issue with the EU’s Council of Ministers and the Commission. “The fate of a bank can’t depend on the situation of the country where it is based.” Without an agreement by the end of March, the proposed SRM and resolution funding plans will lie in limbo for months pending the election of a new Parliament in May.

The ECB has been a vocal advocate of robust resolution tools, and the shortcomings of the existing proposals could cause the central bank to pull its punches as a banking supervisor, critics fear. “Will the ECB dare to be as rigorous as possible with the stress tests if it knows banks can’t be resolved in a proper way?” asks Thorsten Beck, professor of banking and finance at Cass Business School in London. “Supervision without resolution is not worth it.”

Angel Ubide, a senior fellow at the Peter G. Peterson Institute for International Economics in Washington, says the fact that the euro area won’t have a common resolution fund for a decade will perpetuate the balkanization of the bloc’s banking sector along national lines. Banks won’t have any incentive to consider cross-border mergers to strengthen their positions — something the euro’s founders had hoped to foster. “You don’t improve the growth potential of Europe,” Ubide says.

Defenders of banking union prefer to focus on the bigger picture, which they contend has improved substantially. Euro area governments have tackled a number of previously taboo issues since the crisis, including the creation of the ESM and new budgetary procedures that impose tough new constraints on national economic policies. Resolution procedures need improvement, they acknowledge, but investors shouldn’t lose sight of the fact that governments are yielding a large degree of control over their countries’ financial institutions — a dramatic political step.

“Resolution is probably the most complicated thing we have decided since the launching of the euro,” says one senior Brussels official. “The fact that we had an agreement at all is a very important signal.”

Many bankers also profess satisfaction with the resolution arrangements. Alejandra Kindelán, head of research and public policy at Banco Santander in Madrid, notes that EU banks already have raised a significant amount of capital. Also, EU governments agreed in December to introduce so-called bail-in procedures, allowing the authorities to impose write-downs on senior bondholders of troubled banks starting in 2016. Given those provisions, Kindelán says, “the probability of having to go for a lot of public money is very, very remote.”

The Spanish economist welcomes the ECB’s new supervisory role as “a game changer” that will bolster confidence in European banks: “The single supervisor is already a very significant step forward that makes banking union irreversible.”

THE ECB HAS DONE MOST of the heavy lifting to keep the euro together since the outbreak of the debt crisis, and virtually everyone, from politicians to bankers to investors, welcomes its new supervisory role.

“The most important factor for the future of Europe is the restructuring of the banking sector,” says Eric Chaney, chief economist at French insurer AXA and head of research at AXA Investment Managers. “For the first time we will have a fair assessment of the quality of banking assets. If the ECB doesn’t do the job credibly, the whole system will crumble eventually.”

SSM chairman Nouy enjoys a strong reputation in supervisory circles. With 40 years of experience, she knows as well as anyone the intricacies of European banks and the Basel III capital requirements. Although soft-spoken, she has demonstrated a firm hand with French banks, maintaining conservative mortgage lending standards, for instance. “Within the euro system they couldn’t have found anyone better,” says U.K. consultant Green.

Nouy has had to move quickly to prepare for the comprehensive assessment of the banks. Although long rumored to be a front-runner, she was nominated for the post by the ECB in November and endorsed by the Parliament and EU member states only in December. New Year’s Eve is arguably the biggest holiday on the French social calendar, but Nouy and her husband spent this year’s celebration in Frankfurt so she could hit the ground running on January 2.

Many observers question whether Nouy and her team can staff up fast enough to carry out the banking assessment properly. Hiring hundreds of experienced banking supervisors in a matter of a few months is a daunting challenge for a central bank; they will join roughly 80 others already seconded from national supervisory bodies. In January the ECB appointed four director generals to work under Nouy. They include Stefan Walter, an Ernst & Young executive who previously worked with her at the Basel Committee on Banking Supervision, and Ramón Quintana, director general of banking supervision at the Banco de España. The two men will oversee the ECB’s direct supervision of large banks. The central bank also nominated Sabine Lautenschläger, a former Bundesbank vice president and top German banking supervisor, as vice chairman of the SSM’s supervisory board, under Nouy. The move was widely expected after Germany tapped Lautenschläger to replace Jörg Asmussen on the ECB’s executive board in December.

Some bankers mutter that the process is moving too slowly and that the ECB will end up recruiting a disproportionate number of staff from newer member states in Central and Eastern Europe, where generous ECB salaries can be a big lure. Others worry about undue rivalry for staff between the ECB and national regulators. Raimund Röseler, head of banking supervision at German regulator BaFin, complains that ECB pay scales are roughly 30 percent higher than he can offer. “How can we reach a balance between our needs and the needs of the ECB?” he asks.

Establishing a good working relationship between national and ECB supervisors will be vital to the success of the exercise, officials say. The aim is to retain as much knowledge as possible of local circumstances while having strong enough oversight by the ECB to ensure that bank exposures are subjected to the same level of scrutiny from country to country. Previous stress tests failed in good part because the EBA was too new and thinly staffed and depended too heavily on national authorities more interested in portraying their banks in a good light, contends Röseler. “They were not able to challenge the national authorities,” he explains.

In the case of Germany’s Deutsche Bank, for instance, current plans call for the creation of a joint supervisory team comprising about 70 staff from BaFin and eight to 12 from Nouy’s SSM. Röseler says the team will conduct on-site inspections but doesn’t intend to base staff permanently inside the bank, as the Federal Reserve does with big U.S. banks. Although he’s confident the arrangement will work, he adds that “it’s completely new to us.”

The ECB stresses the importance of outside consultants to the exercise. The central bank has appointed consulting firm Oliver Wyman to advise it on the design and conduct of the asset-quality review and the stress test; the firm carried out similar work for authorities handling banking recapitalization programs in Spain and Slovenia. National authorities will also employ outside consulting and accounting firms to help with the work, which the ECB believes will bolster the transparency of the process and enhance market confidence in the outcome. “One element that provides additional credibility is that we have the involvement of independent private firms,” says ECB vice president Constâncio.

Ted Moynihan, head of Oliver Wyman’s financial services practice in Europe, says the firm intends to replicate for the euro area what it did in Spain, where it conducted a detailed analysis of bank balance sheets and then shared the results with investors. “They got a chance to really kick the tires,” he says. “There needs to be much more engagement, much more detail” than in previous EU stress tests.

Nouy and her team plan to focus the work of the AQR on a half dozen or so types of loans that are deemed to carry the highest risks. They include residential and commercial real estate, an area where the size and riskiness of bank activity varies widely by country; shipping loans, in which Germany’s Landesbanks have been the leading players; and credit to small and medium-size enterprises, particularly in Italy. SME loans make up a big proportion of Italian bank balance sheets, and with the country’s long, deep recession putting companies under pressure, the suspicion is that banks are granting excessive forbearance to borrowers to keep them alive. “Italy is the one everyone is looking at,” says the senior Brussels official.

The key to a credible AQR is a single rule book, which will be used for the first time, applying the same rules in a consistent manner across the euro area. To that end, the EBA recently set out clear ground rules for defining nonperforming loans (all credits that are more than 90 days past due or where the borrower is unlikely to pay without a full use of collateral) and forbearance (any credit where a bank grants some type of concession to help a borrower meet its payments).

The region’s big banks welcome the change. “Our big hope is that it will really create a level playing field,” says Stefan Krause, CFO of Deutsche Bank. “With current regulations it’s more difficult to get a true picture of what the real issues are across the banking sector.”

It remains to be seen just how consistent Nouy and her team will be. BaFin’s Röseler cautions that the ECB rule book needs to be flexible enough to reflect the dynamics of specific markets. “They can’t compare a hotel in Berlin with a manufacturing plant in Paris” in assessing commercial real estate exposures, he says. “Harmonization is a good thing, but it should be reasonable.”

The ECB will conduct the asset-quality review on banks’ year-end 2013 loan books. If it uncovers any undue risks or inadequate provisioning for bad debts, the central bank can demand immediate remedial action, such as fresh capital-raising, asset sales or even bank mergers. Nouy expects to finish the AQR in May or early June. Then the ECB will subject the banks’ portfolios to various stress scenarios, such as a sharp economic downturn, completing that part of the process in October.

Officials plan to release the results of both the AQR and the stress tests simultaneously at the end of October. The former should be a fairly detailed report on the overall risk levels at each bank and the health of its loan book; the latter will be a simple number — the amount of additional capital required at institutions that fail the test.

Many analysts, however, doubt that the central bank will be able to stick to that schedule. There will be a roughly four-month period between the conclusion of the AQR and the stress tests, a lengthy period that invites market speculation. “That’s never going to work,” says Laurence Boone, European economist at Bank of America Merrill Lynch in London. “There are going to be leaks and rumors.” In an interview with II, Nouy herself doesn’t rule out the idea of publishing the results of the two exercises separately, but she believes the ECB can maintain confidentiality. After all, she adds, “nothing is finished until the ECB says it is finished.”

The ECB’s assessment of banks’ sovereign debt exposures will draw particular scrutiny from analysts — not surprisingly, given that the link between weak banks and indebted governments lies at the heart of the euro area’s woes. On this score the ECB may offer less of a break from past practice than many investors have been expecting, notably on the zero risk-weighting that the current Basel capital accord applies to investment-grade government bonds. (Banks that use a more sophisticated version of Basel have to apply a modest risk weight to sovereign debt.) Nouy acknowledges that the ECB will apply Basel rules and their zero or very low risk weights when it conducts the stress tests. But she insists that the central bank will be rigorous in its quality assessment of sovereign debt portfolios and believes Basel rules on banks’ funding liquidity create an undue incentive to hold government bonds.

In a January letter to the European Parliament’s Bowles, ECB president Draghi said the risk of an “adverse finding” on sovereign debt in the AQR was low. He added that in the stress tests the ECB would not apply mark-to-market accounting rules to sovereign debt that banks intend to hold to maturity.

To some analysts such comments are anything but reassuring. “In order for the stress test to be credible, they can’t use zero risk weights,” says Cass Business School’s Beck. But some analysts note that spreads on sovereign bonds from peripheral euro zone countries have fallen sharply in recent months, suggesting that many investors believe the worst of the debt crisis is over. On January 22, Spain issued a €10 billion, ten-year jumbo bond at a yield of 3.845 percent, down sharply from 4.45 percent on an issue in May 2012. Investors submitted nearly €40 billion worth of bids for the issue.

Although confidence in the ECB’s ability to conduct a credible assessment of the banking industry is rising, many observers worry about the impact it will have on the real economy.

Total assets of euro zone banks fell by 9 percent, or a hefty €3.3 trillion, between May 2012 and October 2013, according to ECB data. Some of that reflected a winding down of derivatives holdings, but more than half of the reduction reflected the sale or winding down of loans and business lines.

“The ECB feels its reputation is very much on the line from the word go,” says Charles Goodhart, director of financial market research at the London School of Economics and Political Science. “European banks can see this coming a mile off, which leads to more deleveraging, which isn’t going to do much for growth this year.”

BofA Merrill’s Boone estimates that bank credit in the euro area declined by roughly €1 trillion in 2013. She predicts similar deleveraging this year, with a negative impact on the economy. Continued deleveraging is “producing a very slow growth again” in 2014, she says.

ECB officials hope to encourage banks to raise capital rather than shedding assets, but it’s not clear whether they will succeed. “We certainly do not want to see . . . a ‘wrong’ form of deleveraging, a shrinking of assets or constraining credit, that may be detrimental for the real economy,” Ignazio Angeloni, the central bank’s director general for financial stability, told reporters at a recent news conference. “We want those banks [that have shortfalls] to take remedial action, which can take the form of capital increases.”

Few analysts are willing to estimate the amount of capital that the ECB will demand banks raise or how many institutions it will cite, but the central bank will almost certainly find some shortfalls in the stress test. Draghi stated bluntly last year that some banks will have to fail the stress test if the exercise is to have credibility in the market.

Timothy Adams, president and CEO of the Institute of International Finance, says the Europeans are likely to follow in the footsteps of the U.S. in its 2009 stress tests when it comes to identifying capital needs. “The gap needs to be large enough to be credible but small enough that it can be filled,” he says.

The ECB’s assessment appears to have prompted a number of banks to take early action to trim some exposures and business lines. In October, Deutsche Bank announced that it was closing its commodities trading operation because of heightened regulatory pressures but would retain its commodities indexing business. The latter unit, which has nearly $9 billion in assets, entails less risk and requires the bank to hold less capital than trading activities do.

Elsewhere, Belgium’s KBC Group has announced that it plans to incur a charge of €775 million against its fourth-quarter earnings to increase provisions against its Irish loan portfolio in response to the EBA’s definitions of forbearance and NPLs. In January, Italy’s UniCredit sold the junior/mezzanine portion of a €910 million trade finance loan portfolio to Mariner Investment Group, a New York–based credit specialist, to reduce its capital requirements. Credit analysts at Standard & Poor’s expect Italian banks to increase their bad-debt provisions early this year, before the ECB concludes its assessment, following the Italian government’s announcement that it will increase tax deductions for provisions in 2014.

The ECB’s Constâncio puts the deleveraging in a favorable light. “If you look to the statistics, you see provisions increasing enormously in many banks in several countries, with negative consequences for profits,” he says. “But they are increasing the robustness of the balance sheet, and the stock market is recognizing that.”

Huw van Steenis, a banking analyst at Morgan Stanley in London, believes the AQR and stress tests will prod more banks to accelerate deleveraging in their 2013 results and in the first half of 2014 but should leave the sector in a position to revive credit growth over the medium term. “The asset quality review may prove more cathartic than the market fears,” he wrote to clients in a recent research note.

A successful ECB cleanup of the banking sector won’t solve all the euro area’s problems. Anemic growth and mass unemployment risk undermining popular support for the euro and the EU and fueling the rise of euro-skeptic parties. Across Europe politicians, business executives and investors are keeping a nervous eye on the European Parliament elections this spring to see if the right-wing National Front led by Marine Le Pen in France or the anti-immigrant Party for Freedom led by Geert Wilders in the Netherlands can score breakthroughs.

The big risk facing the euro area is that “at some point the population will say ‘Basta,’” says AXA’s Chaney.

After struggling to construct a banking union over the past 18 months, the bloc’s politicians have shown no appetite for the kind of broader fiscal transfers that could help smooth economic imbalances among the member states. “There’s much more integration needed,” Kenneth Rogoff, professor of public policy and economics at Harvard University, told a panel on Europe’s growth outlook at the World Economic Forum in Davos, Switzerland, last month. “You do need some measure of fiscal union.”

Yet after nearly four years of debt woes and crisis atmosphere, many Europeans will be more than willing to declare victory if the ECB can restore some faith in the region’s banks.

“European corporations are in a state of really robust health,” says J.P. Morgan Asset Management’s Macklow-Smith. “The missing link is confidence.” He’s betting that the ECB will deliver one more time. • •

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