Europe’s banks nervously await shape of ECB stress tests

Euro zone banks could be forgiven for feeling a little bit nervous these days, as they await their fate at the hands of the ultimate big Daddy, the European Central Bank. Coming weeks should reveal the shape of the ECB's plans to review banks' balance sheets in advance of the Frankfurt-based institution assuming direct supervision of 130 of the bloc's biggest financial institutions.

The so-called "asset quality reviews", which will be followed by stress tests undertaken by the London-based European Banking Authority (EBA), represent a milestone in Europe's progress towards a banking union. They also pose a potential threat to the relative calm that has descended on the euro zone over the last year.

While ECB president Mario Draghi said on Wednesday he was not expecting any "major disasters" from the tests, privately there is concern in EU circles that next year's stress tests could threaten the very early-stage economic recovery and relative market stability that has taken hold since last year's pledge by the ECB to "do whatever it takes" to preserve the euro.

A lot rests on the quality, scope and parameters of the assessments themselves.

Draghi has said consistently that the tests must be tough and credible, and the ECB is unlikely to want to put its own reputation on the line with a token exercise, particularly as it prepares to assume its role as a supervisory authority for the first time.

The spectre of the European Banking Authority's previous stress tests – which gave banks like Anglo Irish Bank a clean bill of health – also looms large. The appointment of Oliver Wyman, which signed off on Anglo in 2006, as consultants to the project has already raised alarm bells.

On the other hand, there is fear that excessively cautious tests could lead to further destabilisation.

Much as Nama forced banks to crystallise massive write-downs when it bought the troubled commercial loans from Irish banks, the impact of a stringent set of tests on the euro zone economy could prove too much for the financial system, and could be resisted by some member states. Details of the exercise, including how much power will be given to national authorities and how asset quality will be defined, will become clearer by the end of the month.

Bank bailouts
But the most significant question surrounding the stress tests is who will pay for any capital holes that emerge. Outgoing chief executive of Dutch banking giant ING Jan Hommen expressed the underlying concerns two weeks ago. "The question for me is who is going to provide that capital . . . Because I don't think there is a safety net built yet that makes sure that if a bank needs more capital, it is there."

The likely answer is that responsibility will fall back on to national backstops – precisely the scenario the euro zone pledged to avoid when EU leaders agreed to break the link between sovereign and banking debt in June 2012.

This is mainly because the euro zone has yet to establish a pan-European fund to deal with widespread capital shortfalls, despite the shared intent by member states to shift the burden of future bank bailouts away from taxpayers and onto the private sector.

Discussions on how to resolve troubled banks – the second main phase of banking union following the appointment of the ECB as a single supervisor – have not yet delivered results that will be in place in time for next year’s tests.

A number of inter-connected resolution concepts are under discussion. The banking resolution and recovery directive (BRRD), which has involved tense discussions between countries on which class of creditors are hit in the event of a bank wind-down or restructuring, may be signed off by countries by the end of this year but won’t be up and running until 2018.

The inter-connected concept of the Single Resolution Mechanism (SRM), a centralised body and fund which would decide when and how a bank is wound down and which would implement BRRD rules, is also some way off.

Even when established, it could take up to 10 years to build up sufficient funds (which will be paid by bank levies). Suggestions it could be funded in the meantime through a loan from the ESM (European Stability Mechanism) were dismissed by Draghi earlier this month.

Recapitalisation
The ESM itself – from which the Irish Government hopes to secure retroactive direct bank recapitalisation for Bank of Ireland and AIB – has a maximum of €60 billion available for direct bank recapitalisation, deemed to be insufficient for multi-country recapitalisation.

This leaves the problem at the door of national governments. The urgency of finding a solution was suggested by comments from Draghi in recent weeks, in which he highlighted the need to have backstops in place. ECB executive board member Yves Mersch even seemed to suggest the assessments could be delayed in the absence of such provisions.

“Backstops need to be in place before the assessment has begun. Put simply, if there are no backstops, there will be no assessment,” he said

Following Wednesday’s governing council meeting, Draghi made his strongest comment to date on the matter, indicating he was satisfied those national backstops would be in place. Pointing out that the last EU summit had included specific references to national backstops, he said he was “astonished” that doubts had been raised as to whether national backstops would be established.

While this appears to put the ball back in the national court, the use of a national backstop does not automatically suggest the State would be on the hook for the full cost of any fresh recapitalisations.

In the event that a bank needs more capital, new European Commission state aid rules would apply. These rules, which came into effect this summer, would introduce a level of burden-sharing in the event of a bank wind-down. It rules that a bank’s shareholders, junior bondholders and hybrid capital holders are wiped out before taxpayers’ money is used, though it stops short of enforcing losses on senior bondholders.

How far the European Commission will enforce these rules is still unclear, and national governments are likely to have a good deal of discretion on how to implement a bank resolution or restructuring.

Eurogroup chief Jeroen Dijsselbloem also set out a clear scenario in the event of capital shortfalls, explaining that banks would first have to seek additional capital from private investors, then apply the state aid rules before turning to national bank resolution funds or other assistance programs.

The outcome of next year’s stress tests is linked to the broader issue of banking union, the euro zone’s grand plan to sort out its financial sector .

Tense discussions on bank resolution and recovery have delayed agreement on the second phase of banking union, while the third pillar, a common deposit insurance scheme, now looks unlikely.

Germany has an aversion to any scheme that sees a pooling of responsibility for funding weak banks. It has also warned that changes to the EU treaties may be needed for some of the measures, including the SRM proposal. With Germany having garnered significant support for its position at last month’s meeting of finance ministers in Vilnius, the scheme is likely to be altered to take account of Berlin’s preference for a system of national but co-ordinated resolution authorities.

The prospect of some kind of middle-ground on the various stages of banking union worries analysts and investors. Philippe Gudin, chief European economist at Barclays Capital, said a delay in the full implementation of the banking union would be detrimental to the economic situation.

In a paper presented to euro zone finance ministers in Vilnius, Brussels-based Bruegel think-tank urged the eurogroup to implement banking union, highlighting the need to develop a cross-border equity and corporate bond market.

"Banking union is the central front in the management of the euro crisis right now, but it will not be enough to ultimately resolve the European crisis", says Bruegel's Nicolas Veron.

“This will require a much more integrated fiscal and institutional framework, including EU treaty change. Even under the most optimistic scenarios, we remain many years away from eventual crisis resolution.”