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The Mainhattan Project

23 October 2013 By George Hay, Neil Unmack

The European Central Bank has struck a balance between pragmatism and pain. The euro zone’s central bank has lifted the veil on its balance sheet review of 124 banks it will supervise from the end of next year. It has slightly pulled its punches, but in ways that might be justified.

The problem for euro zone banks is that investors don’t trust their capital positions, because they don’t trust the truthfulness of their balance sheets. The central bank wants to address this with a so-called asset quality review, to harmonise the definition of bad loans across the monetary union.

The ECB’s 17-page methodological summary could have been worded more tightly. The national central banks that will conduct the reviews must do so “with reference” to the tight benchmark definitions favoured by the European Banking Authority. That might not be the same as strictly following the guidelines. However, the ECB’s emphasis that it will have the final say could prevent domestic regulators from protecting their lenders – although that means that the hordes of new staff it is hiring must therefore be of the highest quality.

The central bank isn’t that demanding on the capital ratio that will be required of banks after their newly-harmonised balance sheets have been stress-tested. An 8 percent core Tier 1 ratio pass mark under new Basel III reforms sounds tough. But it could have been higher, and it isn’t the toughest “fully-loaded” version. Meanwhile, as was the case in last year’s Spanish stress tests, the capital buffer target will only apply to the stress tests’ baseline scenario – not the worst-case one. Finally, it looks like sovereign debt exposures will be treated more leniently than in the 2011 stress test.

It may have been better and safer to set harder targets. But there is still uncertainty over who will have to fill the capital holes, and the ECB must take care that its exercise to restore confidence in the banking sector doesn’t lead to either bondholder panic, or leave sovereigns overloaded with banking risk. Harmonisation being the immediate goal, the risk of throwing Europe’s fledgling banking union off course wasn’t worth taking.

 

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