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The ECB’s mega-test

24 February 2014 By Hugo Dixon

A lot is riding on the cleanup of euro zone lenders being overseen by the European Central Bank. The progress so far is encouraging. But clarity is needed on a few points to ensure that lenders really do get a good scrubbing and are therefore able to support the zone’s fragile economic recovery.

The ECB is in the midst of a so-called comprehensive assessment of euro zone banks. This has two elements: an “asset quality review” (AQR) to determine whether the loans and other assets held on their balance sheets are valued properly; and a “stress test” to check whether they could withstand a severe economic downturn.

To pass the test, banks are supposed to have a “common equity Tier 1 capital ratio,” a measure of balance-sheet strength, of 8 percent in the baseline scenario; and a ratio of 5.5 percent in the adverse scenario. The whole exercise is supposed to be finished by October before the ECB officially takes over from national authorities in November as lead supervisor for the zone’s banks.

The hope is that investors will at last have confidence that the numbers in bank balance sheets are accurate, so they can lend to banks more freely. Banks would also lend to each other. With the money markets functioning normally again, banks would have more confidence to lend to companies and consumers, giving a boost to economic activity.

That is what happened when the United States put its banks through severe stress tests five years ago. Unfortunately, the euro zone put its lenders through a series of sham tests. They gave clean bills of health to Irish, Spanish and Cypriot banks which virtually blew up soon after.

There are several reasons why things may be different this time.

For a start, this is the first stress test the ECB has overseen. It knows that if it flunks this exercise, its own credibility will be shot to bits.

What’s more, this is the first time the zone has put banks through an AQR. Previous exercises just had a stress test and so did only half the job.

Then there’s the fact that the ECB is using multi-country teams to minimise the risk that national supervisors will turn a blind eye to problems at their local champions. It has also employed outside consultants to avoid groupthink.

Sceptics still fear the ECB will pull its punches because governments haven’t yet spelled out what they would do if banks fail the test and need rescuing. Given that, the central bank will not want lots of lenders to fail as that could trigger a panic, or so the argument goes.

Although all euro zone countries have promised to provide backstops if needed, many haven’t given the details. That’s regrettable. But fears that this will undermine the validity of the tests are exaggerated because the amount of money that might need to be provided by governments is probably quite small.

Note, first, that banks which fail the stress test won’t necessarily have to raise capital so long as they pass the AQR. They may, instead, be able to repair their balance sheets by selling assets and retaining earnings.

But even if they do need capital, many banks should be able to sell equity in the markets. Conditions are much improved compared to the peak of the crisis two years ago. Even Monte dei Paschi, the troubled Italian lender, was able to get an equity issue underwritten last year – although its largest shareholder ultimately vetoed the plan.

Of course, some banks may be so weak that they can’t issue equity. But that doesn’t mean governments have to ride to the rescue. They could force banks’ junior bondholders to convert their debt into equity or even close them down.

Admittedly, in some cases, shutting banks may be too risky, meaning governments may have to bail them out. But don’t expect a flood of rescues. After all, the main problem cases – Spain, Ireland and Greece – have all had mega-bailouts. If top-ups are needed, the sums won’t be as big. What’s more, Greece, perhaps the biggest worry, still has cash in its bank rescue fund that could be used for the job.

Meanwhile, other countries where banking problems could be exposed, such as Germany, are mostly rich enough to fend for themselves. Even Italy can borrow money in the market at attractive rates.

Still, there are concerns. One is that the “adverse scenario” against which banks will be tested will be too soft. The details won’t be published until late April.

Another worry is that banks will respond to the assessment by deleveraging their balance sheets. If many lenders do this simultaneously, that could curtail lending to the real economy and so hold back the recovery.

There is evidence that banks did precisely this late last year, knowing that the assessment would be performed on their end-2013 balance sheets. Those that fail the test may continue to deleverage if they decide this is better for shareholders than raising equity.

It will be hard for the ECB to handle this risk because there could be a conflict between what is good for individual banks and what is good for the macro economy. Managing the conflict will require considerable judgment. That’s why the bank that will be undergoing the severest test in the coming months is the central bank itself.


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