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ECB Said to Favor 6% Capital Requirement in Stress Test

Updated on
ECB Headquarters in Frankfurt
If the European Central Bank determines that the impact of its fictional recession on markets would push a bank’s capital as a percentage of its risk-weighted assets below 6 percent, the lender would then be required to raise capital within a particular time to shore up its defenses. Photographer: Ralph Orlowski/Bloomberg

The European Central Bank favors requiring banks to show their capital won’t fall below 6 percent of their assets when it puts them through a simulated recession later this year, said two euro-area officials with knowledge of the matter.

A majority of policy makers and technical officials have reached consensus on the benchmark for the ECB’s stress test, the people said, asking not to be identified as the deliberations aren’t public. The threshold must still be agreed on with the European Banking Authority that coordinates the exams, and a small number of countries wanting an easier benchmark may press for a compromise lower than 6 percent, one of the people said.

A benchmark of 6 percent would be tougher than the 5 percent set by the London-based EBA in 2011, when models of an economic “adverse scenario” failed to reveal shortcomings at banks that later collapsed. ECB President Mario Draghi has said he’s determined to convince investors that the health check of institutions is thorough and credible as the central bank prepares to take over supervision of about 130 euro-area lenders from France’s BNP Paribas SA to Bank of Valetta Plc in Malta.

Not Final

“At first sight the 6 percent target looks manageable and less ambitious than what people might have expected,” said Antonio Guglielmi, head of equity analysts at Mediobanca SpA in London. “However, given Draghi has been very explicit in willing to carry a tough and credible stress test, this might also imply that the macro adverse scenario the ECB will apply will be much more severe than what the EBA did last time.”

An ECB spokeswoman declined to comment yesterday on the specific number, saying a final decision hasn’t yet been taken and any decision needs to be coordinated with the EBA.

An EBA spokeswoman didn’t immediately respond to a voicemail seeking comment. The authority, whose members include supervisors from the euro region and other European Union countries such as the U.K., was set up in 2011 to harmonize banking rules. The ECB will become a full member of the EBA when it starts supervising euro-area lenders later this year.

If the ECB determines that the impact of its fictional recession on markets would push a bank’s capital as a percentage of its risk-weighted assets below 6 percent, the lender would then be required to raise capital within a particular time to shore up its defenses.

Fed Tests

The stress test “has to be credible or trust can’t return to Europe’s banking industry,” Juergen Fitschen, co-chief executive officer of Deutsche Bank AG, said at an event in Berlin yesterday. “This has to work as otherwise Europe will suffer and growth won’t develop as we want.”

The U.S. Federal Reserve set a minimum 5 percent Tier 1 common ratio for stress tests on the nation’s largest banks to be held this year. That may not be directly comparable with the euro-area test as methodologies could differ.

The ECB’s stress test is the third part of its Comprehensive Assessment of bank balance sheets. The second part, the Asset Quality Review, evaluates lenders’ health under current economic and financial conditions, and sets a minimum capital requirement of 8 percent. That figure was reported by Bloomberg News on Oct. 22 and confirmed by the ECB a day later.

ECB Executive Board member Yves Mersch announced some parameters for the stress test last year, including that it will cover a three-year period. He said the basic economic scenario, before hypothetical adverse events are applied, would use European Commission growth forecasts.

Economic Severity

Elements yet to be provided include full details of the treatment of government bonds on bank balance sheets, and clarification of what counts as capital. The Fed stress tests define capital to be equity.

The setting of the capital requirement is partly determined by the severity of the economic model used. In 2011, the EBA’s “adverse scenario” included a drop in economic output of 4 percentage points from the baseline, implying an increase in unemployment and a decline in house prices. The people didn’t say if the details of the ECB’s stress scenario have been settled.

Draghi said in October that officials won’t shy away from declaring that banks have failed the stress test.

“Banks do need to fail” to prove the credibility of the exercise, Draghi said in a Bloomberg Television interview. “If they do have to fail, they have to fail. There’s no question about that.”

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