ECB Test for Eurozone Banks Lacks Detail, says Fitch

The European Central Bank’s (ECB) framework for its review of eurozone banks appears comprehensive and should be sufficiently robust to bolster investor confidence when completed, says Fitch Ratings.

However, the credit ratings agency adds that the outline is thin on details for identifying banks likely to have capital shortfalls under the asset quality review (AQR) and under the European Union (EU)-wide stress test to be conducted with the European Banking Authority (EBA). Further details on the process would improve transparency and reduce short-term uncertainties, says Fitch.

The eurozone’s largest banks will have to meet an 8% common equity Tier 1 ratio to pass both tests, which will be completed by November 2014, before the ECB assumes the role of single supervisor. This is 1pp above the Basel III minimum, including the capital conservation buffer, so sets a reasonable (though not conservative) standard, especially as the ratio will be adjusted to ensure more consistent application and what is intended to be prudent assessment of assets and risk weights.

The tests are sufficiently robust to lead to capital shortfalls in a few weaker banks. Banks that adopt a more aggressive approach to risk weights or to non-performing or restructured loans are likely to have larger adjustments applied to their reported capital ratios, and so absent substantial capital buffers are likely to be more vulnerable to follow-up actions. Those meeting the 8% risk-weighted capital standard, but with very high leverage, may also be at risk.

Fitch expects capital shortfalls mostly to be met through private means, such as raising equity, cutting dividends, asset sales and liability management exercises. Many European banks are already been bolstering capital using these options. For example, the average Fitch core capital/weighted risks ratio improved to over 11%, from 8.7%, for 25 major western European banks over the two years to end-2012. Exercises like the upcoming tests mean that the impetus to build capital is set to continue.

The CRA adds that a public backstop, if needed, would most likely be provided on a national level. Fitch believe that if state support is used it would be likely to be a small amount relative to the bank’s size and to the capital shortfall identified by the stress test. In this case, the European Commission (EC) can make an exception to the burden-sharing requirements for banks in receipt of state aid.

The adjustment for risk weights should help address investor concerns about the lack of transparency on this metric and resulting inability to compare across banks and over time. There should be a more harmonised treatment for credit and market risk, as the scope of the exercise is broad. For example, the adjustments could reduce variation in the value-at-risk multiplier – a significant source of variation for market risk weights.

Adjustments for asset quality will be focused on the riskiest asset classes, initially identified by national regulators, such as real estate, small and medium-sized enterprise (SME), shipping and legacy structured finance portfolios. The AQR will also concentrate on non-performing and restructured exposures, using the definition published by the EBA this week, and on sovereign exposures.

The 8% capital threshold is based on transitional regulatory metrics rather than fully loaded Basel III, comments Fitch. However, the transitional metric threshold could be tougher to meet if an extended time horizon is used for the EU-wide stress test. Although the 1 January 2014 Basel III transitional definitions for capital will apply for the AQR, the stress test will use definitions valid at the end of the horizon. This could mean that the 8% pass mark is much closer to the fully loaded basis, which will be applicable for EU banks from 1 January 2019. The lack of detail means this is not yet clear.

Another uncertainty is how leverage will be assessed. The ECB has stated that the leverage ratio will provide supplementary information for assessing the outcome, so it is likely to be used as part of the capital adequacy assessment even though a threshold has not been set.

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