Bank Oversight: Europe Stressed by Approaching Stress Tests

By Martin Hesse, Christoph Pauly and

Photo Gallery: ECB Eyes Euro-Zone Banks Photos
DPA

Thousands of ECB auditors have begun examining the balance sheets of euro-zone banks. Stress tests are coming soon. With the European Central Bank in charge of oversight, many hope the EU's financial industry will return to health. But there are risks.

Years of crisis in Europe's banking industry have taught Martin Blessing a thing or two about dealing with adversity. The Commerzbank head jad recently joked with confidantes about how often he and his bank had been left for dead. And yet, both are still around.

Still, Blessing is certainly aware that the ultimate test still lies before him this year -- in the form of balance sheet evaluations performed by the European Central Bank. In an unprecedented effort, the ECB will unleash thousands of auditors and regulators to examine the books of 128 banks in the euro zone. The project is set to be completed before early November when the ECB will assume oversight of the common currency zone's largest financial institutions.

First, a detailed look at the quality of the banks' balance sheets will be undertaken. Then their resilience to potentially adverse market conditions will be tested. At the conclusion of the exercise, the ECB may require some financial institutions to make improvements and could even recommend that some banks be liquidated. "In my entire career, I have never seen anything like" the tests, says one long-serving bank head.

Even if some banks are bound to suffer, the experiment could sound the all-clear the European financial world has long been waiting for -- a new beginning after seven tortuous years of crisis during which hundreds of billions of euros of state help flooded into the sector. Indeed, the ECB is still providing assistance in the form of emergency credit because banks don't trust each other. Were the ailing banks to in fact be eliminated and the rest granted a certificate of financial health, confidence could be restored and dependency on the ECB eliminated.

Yet the project is also a risky one. Should the ECB prove too strict, it could destabilize a European banking sector that has only just begun to show the first signs of recovery. But if it isn't strict enough, or allows itself to be influenced by national interests, the ECB's credibility could be called into question. As such, the stress test will provide the first indication as to whether the ECB will in fact be able to adequately monitor Europe's banks. "We know that we have a single opportunity to establish our credibility and reputation," Danièle Nouy, head of the ECB's supervisory arm, recently told the Financial Times.

'Hobby Gardening Club'

Although the 63-year-old Frenchwoman is so petite she seems to almost disappear behind the podium when she makes presentations, her stern expression gives off an implacable aura. She is aware how easily ECB can embarrass itself in its new role as super-regulator.

Just three years ago, Europe's first monitoring agency, the European Banking Authority (EBA), launched a broad stress test, only to see it fail miserably. The 50-person team in London, which one regulator jokingly refers to as a "hobby gardening club," proved to be completely overwhelmed by the task. The agency's credibility quickly vanished when some banks that had passed the test almost immediately ran into difficulties.

Nouy is thus establishing her severity from the get-go. "We have to accept that some banks have no future," she told the Financial Times. "We have to let some banks disappear in an orderly fashion."

The entire sector is now wondering which banks, and how many of them, might be found wanting. Estimates vary drastically as to how badly off European financial institutions really are. A pair of professors from Berlin and New York recently calculated that the total capital buffer of 109 euro-zone banks is far too small, saying that at least an additional €770 billion (approximately $1 trillion) is needed. A similar study carried out by the OECD found that the euro-zone's 60 largest banks are only lacking €84 billion.

"Supposedly, the ECB intends to fail 30 banks to establish credibility," says Dirk Becker, an analyst with Kepler Cheuvreux in Frankfurt. "If that is true, it could get dicey for German institutions as well, such as Commerzbank, HSH Nordbank or Nord/LB." The US investment bank Keefe, Bruyette & Woods (KBW) believes that 27 banks will fail, but that German institutions will be particularly hard hit. KBW forecasts that eight banks in Germany won't pass the test, almost as many as in Italy and Spain combined.

Auditors taking part in the test are keeping mum. The ECB's specifications have not yet been finalized, says Michael Gättgens, a partner at Deloitte. "Thus, it is hardly possible to reliably assess the possible effects on German banks." Christian Noyer, head of Banque de France, is likewise serene. "I do not expect a big number of banks to fail in the test or a large capital shortfall," he says. "But there may be a handful of institutions where problems yet have to be fixed."

Trouble for Deutsche Bank?

That, though, is easier said than done. In Spain, the number of real-estate loans in default is growing as the crisis continues. In Italy, corporate loans are suffering the same fate amid economic doldrums. Even worse, the balance sheets of many Italian banks are loaded with Italian sovereign bonds, a situation which makes them vulnerable should the debt crisis flare up again.

German banks, on the other hand, are struggling with billions of loans to the shipping industry. With commercial shipping in its sixth year of crisis, large numbers of defaults are looming. One former high-ranking bank manager who focused on shipping says that banks should already have written off up to a third of the money they have tied up in the industry. But Nord/LB, to take one example, has only cleared 10 percent of its holdings from its balance sheet. Commerzbank has refused to say how much of its €14 billion shipping portfolio it has written off.

Even Deutsche Bank, Germany's biggest financial institution, could have trouble passing the stress test, say KBW analysts. The Frankfurt-based bank has a particularly large number of complex securities whose prices are determined by modeling. The ECB intends to take a closer look at the practice.

Yet the regulators may run into trouble. Not only does Deutsche Bank have some €40 billion worth of such securities on their books, but they use several thousand different models to calculate their value. It is "illusory to think you can look at all of them," one supervisor admits. It will likely only be possible to analyze a few such models at random.

Time, after all, is short. The ECB has committed to completing the balance sheet checks in the next three months. The second phase -- that of determining how much capital each bank will need to withstand specific crisis scenarios -- is to begin in May.

Further complicating the effort is the fact that, while the first phase may already have begun, Nouy is still establishing her team. Of the 1,000 employees that she will eventually have, only a few hundred have started work, and many of those are only on loan from national oversight agencies. Four new directors general were named as recently as January. "They first have to figure out how their printers work," one banker complained.

The ECB has thus delegated much of the evaluation to auditors hired by national institutions. They have only recently begun their work -- a situation akin to a team of paramedics beginning open-heart procedure before the doctors arrived. And the banks affected have had little time to prepare. "We still don't have a schedule for the test, no documentation," said one bank employee shortly before the auditors arrived.

Nevertheless, the ECB's aims are ambitious. Auditors have identified 15 risky credit portfolios at each bank for evaluation. Thousands of loans and securities at each institution are to be examined, a number of checks that is four to five times greater than for average year-end statements. Everything is to be questioned: whether the risks have been adequately calculated, what collateral has been established, their most recent appraised value. "The effort is enormous," says one banker.

'The Greatest Worry'

First, though, the auditors have to come to terms with the vast amount of data they are confronted with and somehow establish a method for comparing the banks, which have thus far operated within 18 different legal frameworks and under the oversight of 18 different regulatory agencies. Even the definition of "non-performing loans" is different in many countries: In Germany, the last payment must be 90 days overdue to be identified as such. Some countries accept a longer period of delinquency, others, a shorter one. "The greatest worry among all bankers is that suddenly, standards will be established that didn't exist before," one senior German banker said.

Some governments in the euro zone are thus trying to assist banks in their own country while it is still possible. Spain, for example, recently allowed its financial institutions to book future tax benefits in a way that increased the sector's total capital buffer by €30 billion. Italy too has sought to perk up its banks: Unicredit and co. were to be given the opportunity to increase the calculated value of their Italian Central Bank holdings prior to the stress test.

Germany's central bank, the Bundesbank, put a stop to the maneuver, but Germany too is seeking to protect its financial institutions. Chancellor Angela Merkel's government is pressuring Brussels to exempt capital aid given to state-owned banks from potential European Commission sanctions for violating competition rules. That would help Germany's Landesbanken (banks owned by German states) should the ECB determine that they need fresh capital.

But the European Commission -- which already forced the winding down of WestLB, a Landesbank in North Rhine-Westphalia -- intends to stand firm this time around as well. Additional state aid, Brussels says, could trigger mandatory restructuring at both privately and publicly owned institutions. As such, the ECB stress tests could become a lever for the Commission to further shrink the Landesbank sector.

From the ECB's perspective, governments and banks are too interdependent anyway. That became apparent two years ago when the billions of euros of sovereign bonds found on the balance sheets of banks in Europe threatened to destroy the European common currency.

The Search for Calm

That is one reason Danièle Nouy's agency isn't fond of so-called prudential filters, which ensure that losses occurring as a result of radical shifts on the sovereign bond markets don't immediately affect a bank's capital holdings. Because every national authority has thus far been able to determine by itself the degree to which sovereign bond market shifts must appear on the balance sheet, the prudential filter could have an outsized influence on the stress test results. Many at the ECB would rather exclude the prudential filter entirely.

They are, at least, supposed to be made public. "Then, at least the market could determine the strength of their effect on capital reserves," says Frankfurt-based economics professor Jan Pieter Krahnen.

Nobody, of course, seriously believes that explosive results, should there be any, can be kept under wraps for several months. Indeed, if the ECB isn't careful, their examination of euro-zone banks could actually unleash renewed turbulence instead of calming the markets.

Dirk Auerbach, a regulatory expert with KPMG, believes that releasing too much information could also be dangerous. He says he isn't convinced it is sensible to make the test results transparent. "There is a danger that speculators could target putatively weak banks, thus making their problems even worse," Auerbach says.

Critics of the banking system, such as the analyst Dieter Hein of fairesearch, have other reasons to doubt whether the stress test will make the system as a whole more stable. Financial crises, he says, tend to begin in sectors where they are least expected. "Even the best stress tests won't help," Hein says. "Today you test the shipping portfolio and in three years, the automobile industry plunges into a crisis that nobody foresaw."

As such, it can hardly be expected that complete calm will return to the European banking sector following the ECB evaluations. Some regulatory agencies are already planning for the post-test period. French central bank head Noyer has a proposal that will likely be received with some anxiety by Germany's Sparkassen, the country's small savings banks. "I think it would be a good idea for national supervisors to conduct the same exercise with smaller banks that are not covered by the ECB in the near future," he says.

Translated from the German by Charles Hawley

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