The European Central Bank will outline today (23 October) how it plans to scrutinise top eurozone lenders before becoming their supervisor in a new role that puts its credibility on the line.
The ECB wants to unearth potential risks hidden in banks' balance sheets before banking supervision is centralised under its roof from November 2014 as the first part of a plan for European banking union aimed at preventing financial crises.
That broader plan was drawn up in response to the euro zone debt crisis that undermined economies and financial markets around the world and was made worse by underlying banking weakness in several countries including Ireland and Spain.
The ECB tests should help revive trust in Europe's battered banking sector by aligning countries' definitions of bad loans and the quality and risk weighting of certain assets, helping investors compare banks across borders.
The review will be tough so the ECB does not face surprises once it has taken charge and to avoid repeating mistakes of two earlier European-wide stress tests that failed to spot risks that led to the Irish and Spanish banking crises.
However, if the asset quality review is too rigorous it could undermine confidence in the currency bloc and bond yields could rise again, making it harder for the central bank to fulfil its main monetary policy role of keeping prices stable.
"A poorly-managed exercise would undermine the ECB's credibility as supervisor from day one, with potentially adverse consequences also for its credibility in the field of monetary policy," said Unicredit's chief euro zone economist Marco Valli.
Some ECB policymakers feel uncomfortable taking on the extra responsibility and have suggested spinning off bank supervision into a separate institution over the long term. But such a step would require a change of the EU treaty, which might take years.
The ECB plans to run the asset quality review in the first half of next year, followed by stress tests in cooperation with the European Banking Authority that will look at how banks react under certain shock scenarios. All results are due in October.
Despite the progress on the first leg of the banking union, the second stage – how to salvage or wind down banks that run into trouble – is unresolved as politicians discuss how much of the costs should be shouldered by taxpayers.
Many banks may be unable to raise capital on their own and the euro zone crisis showed that often even national governments cannot afford to stage rescues. In addition to Ireland, Spain – the bloc's fourth biggest economy – had to take international help to tackle its banking problems.
On Wednesday, the ECB will publish a list of the roughly 130 euro zone banks it will supervise directly from November 2014. National supervisors remain in charge of the bloc's smaller banks, but the ECB can intervene if necessary.
The ECB is also expected sketch out for all banks taking part at what stage a loan will be considered to have turned bad and when it is subject to "forbearance" – when a bank revises the terms of a loan when the borrower is in difficulty.
The EBA provided such definitions on Monday and the ECB is expected to adopt them for its review.
A crucial aspect of the review will be how it treats banks' holdings of sovereign bonds. In the current regulatory framework government bonds are seen as risk-free and banks do not have to hold extra capital to back such holdings but this could change.
"No risk-weighting will be attached to (government bond) holdings at this stage, mostly due to the very basic reason that there is no appetite for a move that could trigger an unwelcome liquidation of government securities by their respective domestic banking sectors," Unicredit's Valli said.
Two sources familiar with the matter told Reuters that the ECB will also ask the banks for an 8% capital buffer. That would be a core tier one capital ratio of risk-weighted assets of 7%, as foreseen in the final stage of the Basel III regulatory framework, plus a 1% surcharge for banks that are important to the financial system.