ECB Capital Definition Tougher in Stress Test Than Review

The European Central Bank said it will use stricter rules when stress testing banks’ balance sheets next year than it will to study their assets, as it seeks to prove its credentials as the region’s financial supervisor.

While the ECB confirmed that it will require lenders to have a capital ratio of 8 percent, what qualifies as capital will change over the course of the three-part assessment, the central bank said in an e-mailed statement. The capital definition applicable on Jan. 1, 2014 will be used for the asset-quality review and the definition in force “at the end of the horizon” of the stress test will be used in that evaluation, it said.

Ignazio Angeloni, who is head of the ECB’s financial stability directorate, said today in Frankfurt that officials haven’t yet decided on a timeframe or on details for the stress test. The European Union is gradually phasing in global capital standards known as Basel III, a process which is due to be completed by 2019.

“We’ve got a feasible but safe capital cushion of 8 percent,” Angeloni told reporters. “We want the exercise to encompass all the main sources of risk.”

European officials have entrusted the ECB with overseeing the region’s financial system to prevent a repeat of the turmoil that set off the euro area’s worst recession since World War II. Expanding its mandate from setting monetary policy to direct oversight in 2014 is the most significant revamp in the institution’s 15-year history, and risks putting its reputation on the line as guardian of the euro.

Strengthen Confidence

“A single comprehensive assessment, uniformly applied to all significant banks, accounting for about 85 percent of the euro-area banking system, is an important step forward for Europe and for the future of the euro-area economy,” ECB President Mario Draghi said in the statement. “Transparency will be its primary objective. We expect that this assessment will strengthen private-sector confidence in the soundness of euro-area banks and in the quality of their balance sheets.”

The euro fell after the report and traded at $1.3759 at 9:28 a.m. in Frankfurt. The STOXX 600 financial services index dropped more than 0.5 percent to 325.62.

‘Good Calibration’

The ECB said the 8 percent capital requirement will include a common equity tier 1 ratio of 4.5 percent. On top of that is a

2.5 percent capital conservation buffer and a 1 percent add-on “to take into account the systemic relevance of the banks considered significant,” it said.

“Ultimately it needs to go somewhere higher but where we are now is a good calibration,” Nordea Bank Chief Executive Officer and European Banking Federation President Christian Clausen said in an interview in Stockholm today. “If we get the banking sector there after there is a quality review, then I think we can see very good progress in the European banking sector.”

The definition of capital will become stricter as rules converge to the Basel III requirements.

“It’s good to see a fairly detailed account of how the ECB aims to proceed with its comprehensive assessment of banks,” said Anatoli Annenkov, senior economist at Societe Generale SA in London. “For Europe, it is a potential game changer in the broader context of building a European Banking Union.”

Asset Portfolios

The ECB will commence its study in November and conclude the exercise in October 2014 before assuming supervisory powers over the region’s banks. It will execute a preliminary risk check early next year to identify asset portfolios needing further examination, followed by a full review of the quality of banks’ balance sheets. The European Banking Authority will then help conduct a stress test in the course of 2014 as well as an assessment of their sovereign debt holdings.

The two institutions “will agree on, and communicate, further details on the stress test, the methodology and the scenarios to be used and the correspondent capital thresholds in due course,” the ECB said. It will “soon” convene meetings in Frankfurt with the banks that will undergo the comprehensive assessment.

The ECB identified 124 banks which may be subject to the balance-sheet exam on the basis of data as of the end of 2012. The final list will only be compiled in 2014.

National regulators will run the exercise at the country level, on the basis of centrally developed data requirements and methodology, the ECB said.

Aggregate Data

At the end of the assessment, the ECB will publish aggregate data at country and bank level, together with any recommendations for supervisory measures, the institution said. The evaluation will be published prior to the ECB assuming its supervisory role in November 2014, it said.

If capital shortfalls are identified, banks will be required to adopt “corrective measures,” the ECB said, adding that it will be able to monitor and enforce the implementation of those measures in its new capacity as supervisor.

While today’s announcement offers details of the ECB’s plan on how it will fulfill its supervisory tasks, EU officials are still squabbling over whether enhanced backstops should be put in place to fill capital shortfalls the ECB might identify.

Dutch Finance Minister Jeroen Dijsselbloem has touted indirect recapitalization from the euro-area firewall fund and direct aid to banks in “exceptional circumstances” as credible backstops. Germany’s Wolfgang Schaeuble said last week in Luxembourg that direct bank aid from the European Stability Mechanism would require changes to German law.

ECB President Mario Draghi said on Oct. 2 that it “astonishes” him that doubts have arisen over whether national backstops will be in place by the time the ECB starts supervision. “There is an explicit assurance about this,” he said.