Jan. 14 (Bloomberg) -- The European Central Bank is concerned that national differences in how bad debt is classified could cripple its probe into the health of euro-area banks, according to an internal ECB document.
Bad-debt classification practices across Europe show “material differences that, if not considered, would severely affect the consistency and credibility of the exercise,” according to the undated document obtained by Bloomberg News. A person familiar with the text said it was drawn up in late November and contains the ECB’s latest thinking on the subject. An ECB spokeswoman declined to comment.
The Frankfurt-based ECB is conducting a three-stage assessment of bank assets before it assumes oversight of about 130 lenders across the 18-member euro area this November. Using a strict definition of bad debt could threaten banks in countries hit hardest by Europe’s debt crisis, while a laxer rule may not reveal the true condition of the region’s financial system.
“A more ambitious definition would be consistent with the need to convey to external observers that the AQR is a thorough exercise,” the document said, referring to the Asset Quality Review stage of the Comprehensive Assessment. That’s set to culminate with a stress test run in cooperation with the European Banking Authority before October this year.
The ECB document said that not all countries may be able to comply with simplified definitions of non-performing loans set out in October by the London-based EBA, the EU’s top bank regulator, while saying that alignment to those rules is “of the essence.”
European banks’ bad loans are classified according to a variety of national rules, which makes a comparison among lenders difficult. The European Central Bank is struggling to harmonize the definition of non-performing loans so that it can give more credibility to its assessment of the credit quality of the region’s lenders.
In the first half of last year, total doubtful and non-performing loans as a proportion of lending calculated according to national rules exceeded 21 percent in Greece and were less than 1 percent in Sweden, ECB data show.
“It’s crucial to find common rules and a shared vision to overcome the national lobbies,” Karim Bertoni, a senior analyst on European equities at de Pury Pictet Turrettini & CIE SA in Geneva, said by telephone. “This is the main challenge for the ECB, which would allow a better management of banks and risk control.”
The ECB signaled it would apply the EBA’s simplified definition as a minimum, and where possible increase the level of detail on loans made by banks. The EBA sets financial standards for the 28 nations in the European Union, and is working with the ECB on the final part of the Comprehensive Assessment.
That minimum means the ECB would define as non-performing all exposures, including loans, debt securities, financial guarantees and other commitments, which are past due for more than 90 days. That differs from final, more complex, standards, due to be implemented by EBA by the end of this year, that include data on the likelihood of the borrower repaying. Only half of the countries examined could supply that data, according to the ECB report, while limiting the definition to the 90-day rule “seems feasible for the majority of countries.”
Euro-area lenders from Banco Santander SA in Spain to Alpha Bank SA in Greece will come under ECB supervision, with oversight forming the first pillar of a nascent banking union designed to mitigate future financial turmoil.
ECB policy makers have said the central bank will provide more information on the treatment of non-performing loans and the parameters of the concluding stress test by the end of January.
While the simplified EBA rules should be adhered to in the Comprehensive Assessment as a minimum, adding further detail to the assessment could be possible since ECB officials will already be in contact with bank staff, the document said.
“Given the possibility to perform more granular analysis during the on-site visits, it is proposed that this analysis takes into account a more ambitious definition including the unlikeliness to repay criterion,” according to the document.
The ECB said that as there are so many variations between countries on the definition of forbearance -- where banks shift the terms of a loan to account for a change in the debtor’s own income -- the only possibility is to accept national definitions where they exist, as well as loans that were considered in that category until the end of 2012 but have since been recategorized.
For countries where no standard definition exists, the ECB said it may ask states to report all loans for which concessions have been granted as forborne.