ECB List of Failing Banks Shrinks If You Read Small Print

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ECB Supervisory Board Chair Daniele Nouy
French Daniele Nouy, Chair of the Supervisory Board of the European Central Bank, has said any fresh capital needs should be primarily met by private sources. Photographer: Daniel Roland/AFP/Getty Images

Most of the lenders that failed the European Central Bank’s balance-sheet test have been let off for good behavior.

Only eight banks haven’t already plugged capital gaps or satisfied the ECB with plans to shrink, out of 25 found with a shortfall. That means just 6.35 billion euros ($8 billion) remains from a 25 billion-euro hole, and half of that is in Italy. The ECB, releasing results of its year-long bank audit yesterday, said investors should focus on the insight they’ve gained into lenders’ books instead.

Just over a week before the central bank becomes the financial supervisor of the euro area, officials are attempting to end half a decade of financial turmoil with full disclosure on any bad loans and mispriced assets. The ECB is staking its reputation on this exercise convincing investors that lenders are clean and can again play a role in reviving a stalling economy.

“Some people may wish to conclude that because there is no ‘blood on the street,’ the exercise is not credible,” said Eli Haroush, a fund manager at APG Asset Management in Amsterdam, which oversees 390 billion euros. “I think it is credible. It was a very serious effort and a significant amount of capital has been raised during 2014.”

Small Print

Bank stocks declined today after an initial surge. The Bloomberg Europe Banks and Financial Services Index was down 1.5 percent at 11:15 a.m. in Frankfurt after rising as much as 1.1 percent. Banca Monte dei Paschi di Siena SpA led the decline, losing as much as 17.7 percent. Banca Popolare di Milano Scrl fell 5.2 percent.

While the ECB report shows 13 banks with capital gaps after measures taken this year, footnotes explain that five of them -- two in Greece, two in Slovenia and Belgium’s Dexia SA, -- don’t need to proceed with finding funds beyond what they’ve already raised, or have also reduced balance sheets adequately or are being wound down.

Of the eight remaining banks, four are Italian. Banca Monte dei Paschi has the single biggest gap, and got told to raise an extra 2.11 billion euros. The bank has hired UBS AG and Citigroup Inc. to explore strategic options.

“My gut feeling is, it’s sufficiently credible,” said Barney Reynolds, London-based global head of the Financial Institutions Advisory & Financial Regulatory Group at Shearman & Sterling LLP. “They’ve dragged the banks a long way to what they’re trying to achieve. It should be enough to keep the show on the road.”

Shipping Loans

To pass the Asset-Quality Review, which scrutinized loans on balance sheets as of Dec. 31 last year, banks needed common equity Tier 1, the highest quality form of capital, equivalent to at least 8 percent of risk-weighted assets. In the adverse stress test, the pass mark was 5.5 percent.

No German, French or Spanish bank was sent away with money still to raise. HSH Nordbank AG and Commerzbank AG, two lenders exposed to shipping loans that were singled out in the review, passed outright.

“We were expecting larger capital shortfalls, with banks in more countries emerging with a capital gap,” said Elisabeth Rudman, who heads the European financial institutions team at DBRS Ltd. in London. “We might have expected more capital shortfalls in Spain and Germany.”

Under the simulated recession in the assessment’s stress test, banks’ common equity Tier 1 capital would be depleted by 263 billion euros, or by 4 percentage points. The median CET1 ratio would fall to 8.3 percent from 12.4 percent, the ECB said. ECB Supervisory Board chair Daniele Nouy has said any fresh capital needs should be primarily met by private sources.

‘Full Knowledge’

“This exercise was not about the number of banks that would fail,” Nouy, who will be Europe’s top supervisor starting on Nov. 4, said at a press conference yesterday. “It was about transparency and the full knowledge of investors about the balance sheets of the banks.”

While the exercise didn’t push many banks below the capital benchmarks, the ECB’s efforts to harmonize the classification of bad debt led to a jump in the amount of so-called non-performing exposures. An extra 136 billion euros of non-performing exposures were added, with the stock now standing at 879 billion euros, the ECB report said.

“This whole exercise helps investors by giving them an apples to apples comparison,” said Julia Lu, a partner at Richards Kibbe & Orbe in New York, which advises clients on distressed debt sales. “The market has been frustrated with precisely the issue that the ECB is trying to address, which is that different countries and institutions are using different definitions.”

‘Inflationary Scenario’

Hans-Werner Sinn, President of Germany’s Ifo Institute, said the ECB’s exercise fell short because it didn’t include the possibility of deflation in its stress test scenario.

“With its assumptions, the ECB has set an inflationary scenario on average for the euro area so that not too many banks would fall under the red line,” he said in a statement.

Even banks that failed outright in the review insisted they’ve taken capital measures that haven’t yet been recognized by the ECB. Portugal’s Banco Comercial Portugues SA said it had already taken measures to cover the 1.15 billion-euro gap found in the review.

While the ECB hasn’t turned up a major casualty to prove the toughness of its review, it has still pushed banks to recognize bad loans and raise further capital, according to Richard Barwell, senior European economist at Royal Bank of Scotland Group Plc in London.

“Had they tried to cure the patient all in one go, they could have ended up killing the economy in the process,” he said. “Given the cards they were dealt, they played their hand about as well as could possibly be expected.”

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