European Central Bank to start bank reviews

Stories about bank reviews and stricter requirements have been in the news for years, and Wednesday was no exception. The European Central Bank announced it would begin a comprehensive review of banks throughout the continent. What remains to be seen is if this will actually inspire confidence.

Here’s the story from the Wall Street Journal:

The European Central Bank on Wednesday launched a planned yearlong review of the balance sheets of more than 100 euro-zone financial institutions from Estonia to Germany to Portugal.

The central bank said its aim is to bolster confidence in European banks, which in turn should spur new lending to the private sector and help the economy heal. “A single comprehensive assessment, uniformly applied to all significant banks…is an important step forward for Europe and for the future of the euro-area economy,” ECB President Mario Draghi said in a statement Wednesday.

Previous attempts to test the resilience of euro-zone bank balance sheets, including a stress test in 2011 by the London-based European Banking Authority and a separate capital exercise by the EBA last year, failed to quell doubts. The stress tests in particular were heavily compromised by the lack of political will to provide money to cope with capital shortfalls. A number of banks passed those tests only to collapse shortly afterward.

Despite record-low ECB interest rates and abundant cash in the banking system, lending to the private sector continues to shrink in the euro zone. Small businesses in recession-ravaged southern Europe pay far higher interest rates on loans than their German counterparts, weighing on investment and hiring.

The New York Times pointed out that the ECB is trying to unify regulation were many other government agencies have failed:

The deep dive into bank books is part of a larger attempt to unify Europe’s fragmented banking system under the supervision of the E.C.B., so that lenders in the single currency zone play by the same rules and meet the same standards.

But the E.C.B., with its credibility at stake, must show that it can succeed in eliminating doubts about European banks where other national and European authorities have failed. And it remains unclear who will pay to recapitalize weak banks or how terminally ill banks will be shut down without unleashing market turmoil.

“It’s a once-in-a-lifetime opportunity for the E.C.B.,” said Harald Benink, a professor of banking and finance at Tilburg University in the Netherlands. “They have a clear incentive to be tough.”

Mr. Draghi said in an interview with Bloomberg Television that the E.C.B. would not hesitate to fail banks in a planned test of their ability to withstand shocks.

“Banks do need to fail,” he said. “The test is credible because the ultimate purpose of it is to restore or strengthen private-sector confidence in the soundness of the banks.

“Ultimately that’s the objective,” Mr. Draghi added, “to have private-sector money to be put into the banking industry.”

The review of about 130 large lenders is intended to address one of the underlying problems in the euro zone economy by forcing weak banks to deal with problems such as bad loans or insufficient capital. Credit remains tight in much of Europe, in part because many banks are burdened with bad loans or because they lack confidence from investors and are unable to raise money on capital markets. Without credit a vibrant recovery is almost impossible.

A Reuters story noted that while there is a common supervisor, there is still no system for determining how to unwind banks and who would pay for it:

Wary of a lopsided banking union that could see it supervise euro zone banks without a common backstop in place, it has urged governments to agree on a strong single resolution mechanism (SRM) to salvage or wind down banks in trouble.

However, this second stage of the planned union is incomplete as politicians discuss how much of the costs should be shouldered by taxpayers. Plans for a third stage, a common deposit insurance scheme, have completely stalled.

“The ECB wants to have full responsibility for the assessment, but nothing to do with what has to be done following the assessment, namely the task of the resolution authority. The two things must be completely separated,” Draghi said.

A Morgan Stanley survey of investors showed between five and 10 of the banks to be tested by the ECB are expected to fail the tests and could be forced to raise up to 50 billion euros ($69 billion) to bolster their capital.

The ECB will take a year to go through nearly 130 banks’ books looking for capital issues and other problems, Bloomberg said:

The ECB’s so-called Comprehensive Assessment will start in November and conclude next October. Officials will execute a preliminary risk check early next year to identify asset portfolios needing further examination, followed by a full review of balance sheets. The EBA will then help conduct a stress test and an assessment of banks’ sovereign debt holdings.

“Rigor and transparency from the ECB will be important for credibility of the exercise,” Anatoli Annenkov and Michel Martinez, economists at Societe Generale SA, said in a note to clients. It is “a potential game changer in the broader context of building a European banking union,” they said.

The ECB will use stricter rules when stress-testing banks’ balance sheets than it will to study their assets. For the 8 percent ratio, the capital definition in force on Jan. 1, 2014 will be applied for the asset-quality review. The definition in use “at the end of the horizon” factored into the stress test will be employed in that evaluation, the ECB said.

Angeloni said officials haven’t yet decided on a timeframe or on details of the stress test. The European Union is gradually phasing in global capital standards known as Basel III, a process which will make them stricter over time and which is due to be completed by 2019.

A year is a long time for investors and the market to wait for answers on the health of the European banking system. What will be even more interesting to see is who is going to pay for any resolution and how all those different countries will come together to make a decision. I’m willing to bet that will take longer than a year.