Silence on ECB Bank Review May Break on Legal Blind Spot

Photographer: Ralph Orlowski/Bloomberg

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Photographer: Ralph Orlowski/Bloomberg

The euro sign sculpture outside the headquarters of the European Central Bank (ECB) in Frankfurt, Germany.

The European Central Bank will soon find out how hard it can be to keep a secret.

The ECB’s plan to keep its health check on euro-area lenders under wraps until the completion of a stress test in October could be undermined by national rules requiring disclosure far sooner. Domestic regulators may order banks to tap the market immediately if an Asset Quality Review ending in July shows they need more capital, according to law firms including Clifford Chance LLP.

The risk is that market volatility could rise if multiple announcements cast doubt on the ECB’s control of a process designed to clean up balance sheets. Officials from the 128 lenders in the appraisal are meeting supervisory staff in Frankfurt today for an update on the Comprehensive Assessment, which includes both the AQR and the stress test. The ECB has said the exam will be more credible than previous efforts to restore trust to the financial system.

“This is the biggest blind spot in the ECB’s program,” said Nicolas Veron, a fellow at the Bruegel institute in Brussels and the Peterson Institute for International Economics in Washington. “The banks are still subject to national law, and it’s not clear to me that the ECB had fully integrated this into their planning for the Comprehensive Assessment. They don’t seem to have a very clear stance.”

Due Diligence

The ECB has said the AQR and stress test are related stages in a single exercise and there will be no partial reporting of results before the process finishes in October. The central bank will become the euro area’s bank supervisor on Nov. 4.

“There will be a comprehensive judgment communicated at the end,” Ignazio Angeloni, an ECB official helping to oversee the tests, said in October last year. The institution will announce a “distilled” estimate of capital requirements combining the results of the AQR and the stress test, he said.

An ECB spokeswoman said in an e-mail yesterday that the central bank is drawing up a plan on how to communicate with lenders during the assessment.

ECB Executive Board member Sabine Lautenschlaeger described the AQR on March 20 as part of the central bank’s due diligence before it starts oversight. An index of European bank stocks has risen 1.3 percent this year, compared with a 0.8 percent gain in the broader Stoxx Europe 600 Index, in a sign that the review is helping to boost confidence.

Capital Ratio

At least 1,000 auditors from firms including KPMG LLP and Deloitte & Touche LLP are currently scouring balance sheets across the 18-nation euro area at lenders as big as Deutsche Bank AG and as small as Malta’s Bank of Valletta Plc, looking for misvalued assets and erroneous accounting practices.

Their findings will be used by the ECB in July to judge each bank’s capital adequacy ratio, according to an AQR manual released by the ECB this month. That indicator of financial strength, without being published, will be used as an input to the stress test that will be run by the ECB and the London-based European Banking Authority, the European Union body that sets bank standards.

While the ECB has said it won’t tell banks the results of the AQR, disclosure during the three months before the stress test ends may still be necessary. National regulators will know the AQR results and are obliged to tell a bank if it needs to raise more capital, according to Simon Gleeson, a financial regulation lawyer at Clifford Chance in London.

Disclosure Triggers

The bank must then “as a matter of securities law, disclose a capital shortfall,” he said. “How exactly are the capital markets going to deal with all these banks going to market in the same three month period?”

Domestic regulators should require companies raising capital to “disclose all material information which may have an effect on the assessment of the securities admitted to trading on regulated markets,” according to the European Union’s 2003 Prospectus Directive, aimed at harmonizing market transparency rules across the bloc.

Reporting can be triggered even if the AQR shows a bank has a capital adequacy ratio higher than the 8 percent benchmark set by the ECB. Domestic supervisors can set higher thresholds on individual lenders depending on their risk profiles under European Union implementations of the global banking rules known as Basel III.

Second Pillar

For example, Austria imposed a 2.5 percent capital surcharge on its three biggest banks from last year to account for their risks in eastern Europe. The national supervisor, FMA, could trigger capital increases if the AQR shows this requirement is breached.

Another example is capital requirements ordered in a joint decision of regulators of all the countries in which a bank is active, part of the so called Second Pillar of EU bank rules. Those requirements can also surpass the legal minimum by several percentage points.

The ECB says in its 285-page manual that events that would trigger national reporting requirements, such as the discovery of a breach of accountancy rules, are unlikely. It says it won’t require banks to restate last year’s accounts except in the case of accounting irregularities.

That might not prevent banks from adjusting accounts for the current year. A footnote in the manual states that “there is a possibility that some profit and loss adjustments that will be recognized as a result of the AQR are already booked in interim financial statements before completion of the Comprehensive Assessment.” The ECB hasn’t said how that process will be managed.

‘Capital Cliff’

“In view of the disclosure of the Comprehensive Assessment results in the second half of the year, the ECB is currently drawing up a plan that will define the modalities of interaction with banks during the Comprehensive Assessment and the SSM decision-making regarding remedial actions,” according to an ECB statement e-mailed by a spokeswoman yesterday.

It is hard to believe that information relevant to share prices could be kept secret for three months, said Thomas Koch, a capital-markets and compliance lawyer at Luther Rechtsanwaltsgesellschaft mbH in Cologne. To do so could be destabilizing as it means multiple lenders would have to start preparations to raise fresh funds simultaneously.

“If everyone goes for it at the same time there would be a sort of capital cliff,” Koch said. “I would expect the regulator to call me as soon as possible so that I could take immediate action.”

To contact the reporters on this story: Jeff Black in Frankfurt at jblack25@bloomberg.net; Ben Moshinsky in London at bmoshinsky@bloomberg.net; Boris Groendahl in Vienna at bgroendahl@bloomberg.net

To contact the editors responsible for this story: Craig Stirling at cstirling1@bloomberg.net Paul Gordon

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