As part of its review of 128 lenders, the European Central Bank is studying less-actively traded loans and securitized products that banks value with minimal external data. The unprecedented scope of the exercise gives the ECB, which is taking on a supervisory role this year, insight that has eluded investors: comparing how the biggest investment banks value complex assets.
The findings, to be released in October, could require Deutsche Bank, BNP Paribas and other firms to restate the value of assets, driving down equity and slowing efforts to boost capital levels to meet demands set by regulators, according to Martin Hellmich, a professor of risk management and regulation at the Frankfurt School of Finance & Management. ECB President Mario Draghi, seeking to show the assessment will be credible, has said some lenders need to fail its stress test.
“Banks with a lot of level-three assets that still have a viable business model and funds to spare make for good candidates for the ECB to discipline,” Hellmich said. “That’s a political approach, but it makes sense.”
Banks split assets into three categories: one for those with transparent prices, such as stocks; a second for assets where some external data is available, including many over-the-counter derivatives, such as interest-rate swaps; and a third for those they assign their own values to because there isn’t an active market.
The last group, known as level three, contains the most illiquid asset-backed securities, collateralized debt obligations, repurchase agreements and derivatives. Banks value these assets using their own models based on historical data and risk assumptions. The models aren’t made available to investors.
Derivatives are a broad group of securities that let buyers guard against a borrower’s missed debt payments. Credit derivatives include credit-default swaps, the most common, and collateralized debt obligations.
The ECB plans to publish results of its study of level-three assets along with other discrepancies identified in the asset-quality review in October. The banks will be informed of the findings prior to publication.
The euro area’s 10 biggest banks say their holdings of such assets would have fetched 109.3 billion euros ($146.8 billion) if sold at the end of last year, according to annual filings. On average, 2.5 percent of the fair-value assets at the companies were designated level three, the documents show. The lenders had a combined balance sheet of 11.6 trillion euros at the end of last year.
“Very small changes in the model inputs of those assets can cause significant changes in the valuation,” Osman Sattar, a London-based credit analyst at Standard & Poor’s, said in a phone interview. “The combination of scrutiny of the individual models and comparing them with those of the other banks means it’s an opportunity to make sure everyone is equally prudent in their valuation.”
A bank would have to correct the value of its assets if the ECB says it has misjudged the risk of a position, he said.
Deutsche Bank, Europe’s largest investment bank, and BNP Paribas, which has the biggest balance sheet in the euro area, held the most level-three assets, with 29 billion euros and 24.8 billion euros respectively, the filings show.
A 10 percent drop in the value of Deutsche Bank’s level-three assets would cut the Frankfurt-based firm’s shareholder equity by 5 percent, the most of any euro-area lender, according to Citigroup Inc. analysts who studied 38 European banks.
Group BPCE’s Natixis SA unit, BNP Paribas, Mediobanca SpA and KBC Group would be the next hardest hit, with their equity levels falling about 3 percent each, the analysts wrote in a report published June 16.
While the ECB’s review may force banks to write down the value of their holdings, impairments on level-three assets are still a “manageable risk,” said Kinner Lakhani, an analyst at Citigroup in London.
Ronald Weichert, a spokesman for Deutsche Bank, declined to comment on Citigroup’s calculations or the ECB’s review, as did Julia Boyce at BNP Paribas in Paris, Milan-based Mediobanca’s Stefano Tassone, Ilse De Muyer at KBC in Brussels and a Natixis official in Paris.
The ECB plans to use the asset-review findings to conduct a stress test in September, before taking over supervision of about 120 banks in November. Firms will have six months to raise equity to cover any shortfalls identified in the review or the milder of two stress-test scenarios, and nine months to address deficiencies resulting from the more-adverse scenario.
“We’re confident that the AQR will be both tough and fair,” the ECB wrote in an e-mailed response to questions from Bloomberg News, referring to the asset-quality review. A spokesman for the central bank in Frankfurt declined to comment on which banks or assets might face losses.
Deutsche Bank was criticized by the Federal Reserve Bank of New York in December for erroneous valuations in its U.S. business, the Wall Street Journal reported last week. U.S. regulators are requiring foreign banks operating in the country to hold more capital.
Deutsche Bank said in a statement that the company has “been working diligently to further strengthen our systems and controls and are committed to being best in class.”
Deutsche Bank shares have fallen 19 percent this year in Frankfurt trading, while BNP Paribas has slid 12 percent. They are the fifth- and sixth-biggest losers in the 43-company Bloomberg Europe Banks and Financial Services Index, which has gained 0.9 percent.
Banks have cut the share of level-three assets in their holdings as they reduce risk, according to S&P. Level-three assets accounted for 7 percent of trading assets on average at the end of last year, down from 13 percent in 2009, S&P said in a May report, citing data from 15 global banks.
Deutsche Bank’s level-three assets have shrunk 50 percent since the end of 2009, while those of BNP Paribas fell 29 percent, filings show. Both companies increased the level of disclosure related to the assets over the period.
Deutsche Bank, led by Co-Chief Executive Officers Anshu Jain and Juergen Fitschen, is set to report second-quarter results tomorrow. BNP Paribas, headed by CEO Jean-Laurent Bonnafe, will follow two days later.
“Banks are playing close attention to the economic value of whether they should hold or sell such assets,” said Citigroup’s Lakhani. “There’s a very active market. A number of banks have been selling without necessarily taking big hits.”
Private-equity firms, hedge funds and other specialized investors seeking higher returns have bought illiquid assets from shipping loans to repackaged debt as stimulus measures by central banks depress bond yields.
Gregory Turnbull-Schwartz, a fund manager at Kames Capital Plc in Edinburgh, said his firm compares a bank’s level-three assets with its equity when deciding whether to invest in its debt. The investor, who helps manage 52 billion pounds ($88 billion) of assets, including bank bonds, didn’t name lenders he avoids or considers risky enough to demand a premium from.
“We look a little bit more favorably on the ones that at least seem to be trying to get rid of these things,” Turnbull-Schwartz said. “If it’s going the other direction, it means they’re asleep at the wheel, or not that bothered really about getting rid of these really illiquid things.”
Banks also have prepared for the asset review by raising provisions for bad loans, shrinking total assets and selling shares to increase equity. Lenders have bolstered their ability to withstand losses by about 198 billion euros since July 2013, ECB Vice President Vitor Constancio said this month.
Deutsche Bank’s common equity Tier 1 ratio, a measure of financial strength, rose to 9.5 percent at the end of March from 8.8 percent a year earlier, while BNP Paribas’s increased to 10.6 percent from 10 percent, company filings show.
As the costs of legal settlements and regulatory fines for past misconduct eat into banks’ capital, Deutsche Bank sold 8.5 billion euros of stock in May and June to provide a buffer against future capital requirements.
Deutsche Bank probably will set aside 5.2 billion euros for legal matters this year and next and needs 5 billion euros of additional equity to keep pace with the capital levels of competitors, Andrew Lim, a London-based analyst at Societe Generale SA wrote in a July 21 report.
Twenty-one of 44 analysts tracked by Bloomberg say investors should buy Deutsche Bank shares, while Lim and four others recommend selling. Seventeen of 38 analysts say investors should buy BNP stock, while three recommend selling.
BNP Paribas’s $8.97 billion penalty for violating U.S. sanctions will cut its common equity Tier 1 ratio to about 10 percent at the end of June, the bank said June 30.
Banks may be able to take some of the sting out of any shortcomings the ECB finds by showing investors they will comply with standards published by the European Union’s top banking regulator earlier this year, according to S&P’s Sattar. In March, the European Banking Authority published standards for valuing trading-book assets more conservatively than existing accounting rules require. Many of those assets are typically classified as level three.
Applying the standards to 59 banks the EBA studied would require them to set aside 13.4 billion euros, or 1.5 percent, of their total common equity Tier 1 capital, the regulator said, without naming the lenders. The rules would sap Deutsche Bank’s capital by as much as 2 billion euros, the firm said April 29.
The central bank’s review will examine the trading books of 29 companies, including the euro area’s 10 biggest lenders.
“Regulators have been aware of the fact that banks have very different models, and we haven’t necessarily solved that issue,” said Hellmich, the finance professor. “Many supervisors aren’t keen on the idea of allowing banks to run with their own models, so the ECB may give them a harder time now to push them onto a standardized approach.”
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