ECB at Loggerheads with Policymakers Over Banking Stress Tests

Jörg Asmussen is introduced as someone who "was in the eye of the storm." After five years of the financial crisis, Asmussen, who is bald and walks with a slight stoop, is taking stock before the attendees of a conference at a Frankfurt hotel.

But Asmussen, a former state secretary in the German Finance Ministry, doesn't spend much time dwelling on the past. Today he is a member of the executive board of the European Central Bank (ECB), which is currently launching a large-scale project to finally clear away the toxic assets left over from the crisis and build a new firewall, the European banking union. The first part consists of a balance sheet test. The ECB plans to put 130 major banks to the acid test before it assumes regulatory supervision of the institutions in the fall of 2014.

"This test is not a threat," Asmussen tells his audience. "But after two failed stress tests, this is the last opportunity to reestablish confidence in the European banking system."

A comparison with the United States shows what bad shape the industry is in. US financial groups are reporting record profits, while banks in the euro zone have lost more than €80 billion ($108 billion) in the last two years. The Europeans failed to adequately address their banking crisis. In the United States, 10 times as many ailing banks were closed and balance sheets were more consistently relieved of bad debt than in the euro zone. The ECB stress test is intended to introduce a long-overdue spring cleaning in Europe.

Banks that do not do well in the test will have to establish a larger cushion of capital or jettison risks. The ECB has repeatedly made it clear that it will not take on rotten eggs.

'We Will Not Make the Test Soft'

But the balance-sheet test also plunges the new regulatory structure into conflict. On the one hand, the ECB will have to produce a strict test to be credible from the start. The member states don't want to be humiliated by the test and will do everything they can to make their banks look good. This is why Asmussen warns: "We will not give in to the temptation to make the test soft."

On the other hand, the ECB runs the risk of producing new turbulence in the banking system with a strict test. "The test could be the trigger of a new escalation of the crisis," says the head of a German bank. He notes that as soon as it becomes clear which criteria the ECB is applying for its test, European lenders will come under heavy pressure to raise money. The future regulator plans to reveal initial indications about the standards it will set in mid-October.

Initially, the ECB will want to obtain an overview as to whether the banks have viable business models and where their greatest risks lie. The assessment of balance sheets will follow in the first half of 2014. The regulators will check to determine whether banks have assigned the correct value to their loans and bonds. The actual stress test will likely begin at the same time. It consists of a simulation to determine whether the banks would survive an economic crisis. The goal is to determine how much money the lenders lack by the fall of 2014. But the banks can't wait that long to raise capital, because the ones that lack capital will know earlier how much they need, and they will come under pressure from investors and rating agencies.

Estimates have already been made over the potential magnitude of the gaps the test will uncover. Deutsche Bank estimates that Europe's banks will need €16 billion in additional capital. Depending on which criteria the ECB applies in its tests, the gap could be much bigger. The Bundesbank, Germany's central bank, has just estimated that the seven largest German banks alone need an additional €43 billion in capital to satisfy the new international capital requirements.

These rules will only gradually take effect between now and 2019. Nevertheless, there is speculation in financial circles that the ECB is inclined to apply the stricter criteria in its tests early on. Large sums can already accumulate as a result of standardization of assessment standards, which currently differ among euro countries.

Ship Financing Loans in the Spotlight

Among German banks, the regulators will be paying especially close attention to ship financing. Commerzbank alone still has €17 billion in ship loans on its books, of which it has classified €4.6 billion as troubled, meaning that some of these borrowers are likely to default. The bank has written off about €2 billion, but is that enough?

The bank has not classified many loans as troubled. Instead, it has accommodated borrowers in various ways, including lengthening repayment periods. If the ECB decides that these loans must also be written off, analysts believe that Commerzbank could be forced to make billions in further adjustments. This doesn't even account for additional cushions against a recession.

HSH Nordbank, whose government owners have just had to bolster their guarantee because of the problems with bad ship loans, will likely face even greater challenges. The state-owned bank Nord/LB could also need additional funds. "We do not anticipate additional capital needs following the balance-sheet analysis," CEO Gunter Dunkel says optimistically. But the additional capital burdens emerging from the stress tests will ultimately depend on how stringent the ECB's requirements are.

Nevertheless, German financial regulator BaFin takes a relaxed view of the issue of ship loans. Sources familiar with the supervisor's view say that the ship loans were regarded as being properly valued under existing regulatory criteria as of the end of June. This means that BaFin would have no legal right to demand more capital from the banks. Still, the ECB test could make capital increases necessary.

Studies by analysts have also identified a substantial need for capital among Italian, Spanish and Irish banks, and there are likely to be troubled candidates in almost every country. But what happens if the regulators discover a large gap? When pressed for time, many banks will have difficulty in finding investors on the market. The test could also prove some institutions not to be viable in the long run.