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Loopier and loopier

1 October 2014 By George Hay

The euro zone’s nascent banking union was supposed to unpick the “sovereign doom loop” by which ropey banks endangered weak countries, and vice versa. Its first task was to be a rigorous test of how much capital each lender could count on in adverse scenarios. Yet the new single banking supervisor’s exercise could tighten, rather than loosen, the state/bank co-dependency.

The tests, scheduled for release on Oct. 26 with input from the European Central Bank, will subject the monetary union’s lenders to a generic macroeconomic shock. They will be required to show that their core Tier 1 equity afterwards would amount to at least 5.5 percent of their risk-weighted assets. But the ECB’s single supervisory mechanism, which will directly regulate large European banks as of Nov. 4, has acquiesced in making this “pass” mark easier, according to a person familiar with the situation.

The fudge concerns deferred tax credits, or money governments owe the banks when they have booked losses in previous years. National regulators in Europe have found a way around Basel III capital rules that require a variant of these, so-called “deferred tax assets,” to be phased out of a bank’s capital count by 2018. DTAs generally only kick in once a bank becomes profitable again – so they shouldn’t be viewed as loss-absorbing capital.

Tax credits, on the other hand, are due whenever a bank needs them. Italy, Spain and Portugal have already shifted many DTAs into various types of DTCs. Greece is following suit. That can be a significant boost for the banks: DTAs make up over 15 percent of Portuguese lenders’ capital on average, and 30 percent-plus of some Greek banks.

Allowing DTCs not only weakens the test’s credibility. It also restores the tie between sovereigns and their banks. True, in some cases, attempts are made to safeguard the governments’ finances by allowing them to take an equity stake in the stricken lender. But as the ECB itself warned in a pointed opinion note on Sept. 3, it would be healthier if banks raised the capital they need privately. Given that the central bank’s SSM offshoot is the European banking regulator in waiting, it has the power to impose tougher rules on prudential grounds if it wanted to. It hasn’t.

Two factors point to why. One is that at the moment, the ECB is torn between its two partly conflicted roles. As banking supervisor, it must be tough on capital. As central bank, it fears deflation and wants to boost lending in the euro zone – which will be hard if capital needs push banks into a new wave of deleveraging. There is a theoretical Chinese wall between the board of the SSM and the ECB’s governing council in charge of monetary policy, but it would be odd for the former to further complicate the job of the latter – especially as there is some overlap between the two in terms of personnel.

But there is another problem. Although the 23-strong SSM board is chaired by the tough-talking Daniele Nouy, 18 of its members are representatives of national regulators. They either already accepted DTCs as capital, or are likely to acquiesce in return for concessions that could help their own banking system.

The SSM’s overall “comprehensive assessment” should still be a step forward. A pan-euro zone definition of bad debts should at least make the denominator of the capital ratio credible – and comparisons possible. And once the test is done, the new supervisor could still slap extra capital requirements on banks that gorged on DTCs.

Yet any attempts to toughen up will still have to get past the SSM board. And by allowing banks to hold “capital” that rejoins them at the hip to their own state, the stress tests will be less meaningful than they could have been. Worse, investors could continue to treat them with suspicion.

 

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