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06/12/2016

Credibility meets compromise in Europe’s bank stress test

Euro & Finance

Credibility meets compromise in Europe’s bank stress test

The ECB's headquarters is the only earthquake-proof building in Frankfurt. [Adam Baker/Flickr]

When Europe announced its latest health check of top banks early last year it promised a “comprehensive assessment” of how well prepared they were to withstand another financial crisis.

In practice, a spirit of comprehensive compromise has been just as important.

A series of Reuters interviews with officials, bankers and others involved in the European Central Bank’s financial inspection of the eurozone’s biggest banks shows that in the seven months since it began, the ECB has had to shoot down countless pleas from banks and national supervisors for special treatment.

At the same time, according to sources who spoke on condition of anonymity, supervisors have revised the way they value assets and banks have failed to provide all the data demanded – multiple compromises that could cumulatively threaten the tests’ reputation as tough and consistent.

The ECB, which takes over as supervisor for the region’s top banks on 4 November, declined to comment in detail on the issues raised but insisted the exercise was robust and thorough.

It will announce on 26 October which of Europe’s 130 biggest banks have valued their assets properly and which have not, as well as whether banks need more capital to withstand another economic crash. Anticipation of the results is already affecting bank shares, with Italy’s Monte dei Paschi falling to an all time low last week amid fears it would be forced to raise more cash.

“This health check […] is unprecedented in terms of scale, rigour, severity and transparency,” a spokeswoman said.

“It provides in-depth information on the condition of the largest banks in 19 countries and aims to strengthen banks’ balance sheets by identifying problems, build confidence and enhance investors’ trust.”

That said, one of the first compromises of the process came just two months into it, when the ECB privately acknowledged, according to sources with knowledge of the discussions, that there were “real dangers” of negative consequences if the banks were kept in the dark about how they were faring right up until the results were announced.

The auditors were then allowed, for the first time, to begin sharing information with the banks they were reviewing.

“We would take a file with the largest [loan loss] provision movement [and] told them why we were uncomfortable with provisioning that area,” said one source familiar with the meetings.

The banks could then work out the maximum adjustment to provisions they were likely to face, the source said – a key clue to the ECB’s final assessment of whether they would have to raise more capital or rein in dividends.

“You knew what the major drivers were,” confirmed one senior banker who attended meetings for his company. “I don’t expect any surprises.”

Around the same time, Daniele Nouy, the head of the ECB’s supervisory arm which is leading the exercise, spoke publicly of the importance of banks being given a “right of reply” to the ECB’s findings.

Earthquake proof

The original process started with just ten ECB employees. More staff and consultants joined the team – which later moved to Frankfurt’s only earthquake-proof building – to spend hundreds of hours crunching the numbers.

A project manager was hired in September 2013 in the form of Oliver Wyman, a management consultancy headquartered in the United States.

A month later, when ECB president Mario Draghi met the chief executives of the banks that would be tested to try to convince them of the exercise’s worth, information was still sparse.

A draft methodology was finally circulated in January 2014 between some national regulators and auditors, as well as ECB officials and the Oliver Wyman team. Details of what was christened the Asset Quality Review (AQR) were kept secret by personal non-disclosure agreements which included a fine of €100,000 for any breach.

On 17 February, the ECB held its first meeting with the experts who would participate in the AQR. Executives from Oliver Wyman faced a crowd composed of national regulators and consultants in the same room in which the ECB gives its monthly press conference on interest rates.

One attendee described the meeting as “antagonistic”, with delegates struggling to follow the logic of parts of the approach outlined in a 300-page draft manual.

At a second meeting, a few weeks later, patience was in even shorter supply: Two sources present said an Oliver Wyman representative responded to one question with the words: “It is not beyond the wit of man to follow the manual.”

For the institutions about to be reviewed, it appeared very much to be “the Oliver Wyman show”, said one banker who was a central figure in his bank’s engagements with the ECB. “The ECB was relying far too much on its consultant,” the banker said.

Oliver Wyman declined to comment on any aspect of this article, citing client confidentiality.

Concessions

There were not many more meetings before the test manual was published in mid-March.

“The time pressures the ECB was forced to operate under meant there was not really a lot of scope or time for consultation with banks,” said Robert Priester, deputy chief executive of the European Banking Federation.

While banks were getting to grips with the level of scrutiny to which they would have to submit, the manual also showed investors why this round of bank tests would be more transparent than previous ones in 2009, 2010 and 2011, sources said.

Work got underway. National supervisors settled into their new roles as buffers between their banks and the ECB. The ECB battled for consistency. National authorities pushed for concessions. But the latter had limited power.

“The whole process was very prescriptive… (What the national supervisors did) was common sense decision making,” one national supervisory source said.

Patriotism sometimes intruded.

“That is obvious, that you try to protect your own banks,” a second national supervisor said. “You would not like to see banks in your country fail.”

April and May saw the granting of a major concession, three sources said. Working out the value of banks’ collateral, auditors were initially only allowed to consider developments up to December 2013. This was moved to the end of March 2014 for some countries, including Portugal and Belgium – allowing banks to incorporate more recent values of their assets as those values started to rise.

“It was a pragmatic view, it was quite difficult to argue with the logic of taking the old value,” one source said.

Another concession related to shipping loans. In working out their value the ECB originally wanted to discount cash flow models that based a ship’s value at how much income it would generate for its owner in the future, and instead value ships based on how much they would sell for. Eventually it agreed to accept the discounted cash flow models so long as the final valuation was reduced by about 10%, sources said, below what the bank initially recorded.

Almost every bank failed to follow at least part of the methodology the ECB wanted them to use to simulate how they would perform in a crisis, said one source familiar with the exercise. They are hopeful that the ECB will allow them a little wriggle-room, said one banking regulation expert familiar with the process, having seen it become more adaptable as the process went on.

“The ECB backed down to some extent. You could also say they became more realistic, because they realised (the) huge resistance among banks,” the expert said.

Deadlines and traffic lights

With so much riding on the stress tests, political interest was inevitable.

Officials were limited in what they could tell politicians about how the test results were shaping up, so briefings focused on the amount of capital banks had already raised, a sum that totalled €100 billion between mid 2013 and September 2014 according to the ECB’s estimates

The actual scenarios – theoretical economic shocks that banks had to prove they could weather – were not publicly disclosed until April.

The detail of the scenarios was devised by the European Systemic Risk Board, a group chaired by ECB president Mario Draghi that was set up to improve financial supervision, in consultation with officials from national eurozone regulators and the EU’s banking regulator the European Banking Authority. Those details were hard fought, sources say – in particular the size of the fall in economic growth, property prices and employment that banks should have to prove they could withstand in different countries.

Many thought the ECB’s final deadline would have to move, given the almost weekly demand for more data.

But it kept the banks in line with a daily traffic lights system showing which banks had fallen behind – a mechanism some bankers told Reuters looked like a kindergarten exercise.

But, said one source familiar with the design, “It worked.”

After a quiet August, the ECB began discussions at the end of September to forewarn banks of major issues that had appeared in the test results – without giving them so much information they would be forced to immediately disclose it to investors.

As the exercise draws to a close, most believe that this time around, the results will deliver a convincing verdict on the health of Europe’s banks.

“This is the fourth exercise and – I hope – the last,” said one official.