'Over-Banked' ECB Tests Set to Reveal German System Flaws

The European Central Bank's upcoming review of the euro zone's largest banks could expose weaknesses in the German banking sector. It may also reveal Germany's political role in limiting the scope and efficacy of the Continent's nascent banking union.

European Central Bank headquarters in Frankfurt.
REUTERS

European Central Bank headquarters in Frankfurt.

By Christopher Alessi


The European Central Bank is preparing to conduct a "comprehensive assessment" of the euro zone's biggest banks ahead of taking on the role of banking supervisor for the region late next year. German banks, considered some of the strongest in the fragile euro area, are expected to fare relatively well. However, a thorough -- and apolitical -- review could reveal cracks in the German financial system, while underscoring Germany's fundamental resistance to a full-fledged banking union.

Earlier this month, European Union finance ministers officially signed off on plans to create a Single Supervisory Mechanism within the ECB, which will monitor around 130 of the euro zone's largest banks. The step is the first in a larger EU plan to shift financial regulatory authority from national governments to the European level by developing a so-called banking union.

However, the ECB, starting in November, will first assess the health and stability of the big banks through an evaluation that includes a risk assessment, an asset quality review, and a stress test targeting bank balance sheets. The review, which will be based on a capital benchmark of 8 percent, should "strengthen private sector confidence in the soundness of euro area banks and in the quality of their balance sheets," ECB President Mario Draghi said when the bank outlined its assessment criteria on Oct. 23.

Bank analysts and economists expect some banks in Italy, France, and Spain to require additional capital following the evaluation, in large part due to non-performing loans. But what about German banks?

'Too Many Banks'

"In the European context, German banks are much stronger than others, so the adjustment will probably be a lot smaller," says Marcel Fratzscher, president of the German Institute for Economic Research. However, he warns, "Commerzbank is a big question mark."

Fratzscher says it is not clear whether Commerzbank has a sustainable business model, like that of its well-capitalized competitor, Deutsche Bank. "It's not an international player, and it's not reaching a lot of private companies and households in Germany," Fratzscher explains. He suggests that the German government, which has held a 17 percent stake in Commerzbank since the global financial crisis, might ultimately need to inject more liquidity into the bank or "scale it down." Similarly, a European bank insider, who spoke on the condition of anonymity, says he could envision the government re-privatizing Commerzbank by selling to a buyer like UBS, which could lead to a "winding down" of the bank.

Part of Commerzbank's trouble stems from its large exposure to poor shipping loans. "It's taken huge losses and can't find anyone to sell its shipping portfolio to," says Megan Greene, chief economist at Maverick Intelligence. Commerzbank's exposure to non-performing shipping loans increased from 21 percent to over 25 percent between November 2012 and June 2013, according to a recent report on the planned asset quality review by Nomura Equity Research. But Commerzbank is not the only German bank facing challenges ahead of the assessment.

"I think shipping loans is a higher risk area for a number of German banks, and as in previous stress tests one of the key challenges will be the comparatively low level of Basel III core Tier 1 [capital ratios above 7 percent] as a starting point," notes Jon Peace, a Nomura analyst. Other German banks with high shipping exposures are two of the publicly-owned Landesbanken, or regional banks, including NHS Nordbank and Norddeutsche Landesbank.

Those regional banks are part of what Carsten Brzeski, chief economist at ING DiBa bank, calls Germany's "over-banked" system -- including private commercial banks, savings and cooperative banks, and the Landesbanken. "There are too many banks in Germany," Brzeski says, suggesting that the upcoming ECB tests could provide an opportunity for a consolidation of the sector.

More broadly, a functioning and effective banking union would "imply some adjustments" for German banks, says Jan Pieter Krahnen, director of the Center for Financial Studies at Frankfurt's Goethe University. "There will be adjustments -- consolidation -- for the big banks, as well as for the savings banks and the smaller regional banks," Krahnen explains.

A Forceful Backstop

There remain a number of unsettled elements that make such a comprehensive banking union far from complete. These include the development of a Single Resolution Mechanism for addressing weak banks, the harmonization of standards for certain loan classifications and bank assets, and a deposit guarantee fund.

The resolution scheme has proven particularly controversial because it entails the creation of a central joint fund that would act as a backstop for struggling banks. In the long term, the banking industry would finance the fund, but in the short term, national governments -- potentially through the European Stability Mechanism -- might have to guarantee loans to failing banks. Germany has forcefully opposed such a move, which could theoretically force German tax payers to bailout banks in, say, Spain or Italy.

German Finance Minister Wolfgang Schäuble recently insisted that senior and junior bank creditors would have to take full losses -- so-called bail-ins -- and German law would have to be amended before Germany could agree to assist with the recapitalization of euro zone banks. But Chancellor Angela Merkel later tweaked the government's position, at least rhetorically, indicating that she could potentially support a joint resolution mechanism under certain conditions: namely, that private creditors and bondholders be liable first, and that any government assistance be approved by national parliaments. Meanwhile, Draghi said in a recently leaked letter to the European Commission that forcing losses on bondholders before a banking union is up and running could destabilize markets.

The irony of the firm German position, as former ECB executive board member Lorenzo Bini Smaghi sees it, is that the recapitalization of German banks in the wake of the financial crisis was among the largest in Europe. The Germans "have never 'bailed-in' anybody," Bini Smaghi says, "their banks have always been bailed out." He faults Germany for its insistence on a "system they have never tried at home and writing rules that put you in a straight jacket," which he suggests could create conditions that ultimately trigger a run on banks.

Without agreement on a forceful backstop, or resolution mechanism, many analysts and economists question whether the upcoming ECB assessments can actually be meaningful. "The backstop is the key thing for this test," says Krahnen. The ECB is in a tight corner. If the bank does not conduct a "serious" review of banks, it will not be able to operate effectively as a banking supervisor down the line, Krahnen says. But if it does operate a genuine comprehensive test with no resolution mechanism in place, many banks "will be in trouble soon," he explains.

Greene, of Maverick Intelligence, bets that the asset review and stress tests will ultimately be a "big fudge." "Europeans are not really sure what they'll do with the results. There's no fund for big recaps," she adds. Ultimately, she argues, Germany will get its way regarding the joint backstop. National supervisors will continue to have a large role in the bank resolution process, which, Greene says, will make the new system more of a "banking confederation" than a banking union.

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