Euro-Region Banks Seen Accelerating Cleanup Before ECB Exams

Euro-area banks are likely to step up efforts to bolster their finances after the European Central Bank outlined its plans to scrutinize their health.

“I expect higher provisions from banks in the fourth quarter, ahead of the ECB’s review,” Ronny Rehn, an analyst with Keefe, Bruyette & Woods in London, said in a phone interview. “All the banks will be stressed, so all the banks have similar incentives to look better.”

The ECB will go through the accounts of about 124 of the region’s banks in a three-step process starting next month. Examiners will first identify potentially problematic loans, then review banks’ balance sheets in early 2014 and conduct stress tests before officially taking over as banking regulator a year from now, the central bank said yesterday.

Citigroup Inc. analysts including Ronit Ghose and Kinner Lakhani expressed surprise at the scope of the ECB’s review in a note to clients, including the degree to which the Frankfurt-based central bank will examine the most hard-to-value assets and those held off balance sheets. The 28-company Euro Stoxx Banks Index fell the most since Aug. 27 on speculation the ECB tests will force some lenders to tap shareholders or government coffers for capital.

“We remain concerned about the volatility the asset quality could usher in,” Morgan Stanley credit analysts, led by Jackie Ineke in Zurich, wrote in a note yesterday. “We expect significant capital shortfalls and as part of this, a number of banks may need to rely on state aid.”

‘Need to Fail’

ECB President Mario Draghi said officials won’t hesitate to fail banks in its stress tests next year as the central bank sets out to prove its vigilance as banking supervisor.

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

Europe’s leaders have entrusted the ECB with overseeing the euro area’s financial system to prevent a repeat of the turmoil that set off the bloc’s worst recession since World War II. Investors, who have rewarded Europe’s best capitalized lenders with lower borrowing costs and higher share prices, will be able to use information on which firms carry the most risk next year.

“The banks will take a pretty thorough review of provisions and take necessary corrective measures well in advance of the completion of the asset quality review,” Thomas Huertas, a London-based partner in Financial Services Risk at Ernst & Young, said in a phone interview.

Spanish Loans

Some banks have already set aside more money for doubtful loans. Spanish lenders, including Banco Santander SA and Banco Bilbao Vizcaya Argentaria SA, booked 86.6 billion euros ($119.4 billion) of asset impairments in 2012 that contributed to industry losses of 53 billion euros as they submitted to government orders to clean up their balance sheets, according to Bank of Spain data. The government set up a bad bank to absorb 50.4 billion euros of assets linked to real estate from lenders that took state aid.

Bank of Spain Governor Luis Maria Linde has said the country’s banks will start the ECB reviews “from a very reasonable level.”

What’s not known is how non-real estate assets including corporate loans and the almost 600 billion euros of household mortgages will withstand an economic scenario such as that outlined by the International Monetary Fund, which predicts the unemployment rate won’t fall below 25 percent until 2018. Joblessness in Spain stood at 26 percent in the second quarter.

Italy Provisions

Italy’s central bank started examining the assets of 20 of the nation’s lenders last year, conducting a local review ahead of the ECB’s assessment. The Bank of Italy forced banks to set aside more loan-loss provisions starting in the fourth quarter of 2012.

Intesa Sanpaolo SpA, Italy’s second-biggest bank, increased its bad-loan coverage ratio by 1.5 percentage points to 44.2 percent by June 30 from the end of last year, while UniCredit SpA reported a ratio of 44.1 percent in June, up from 43.5 percent recorded a year earlier.

Even so, “for the next year, we expect that the Bank of Italy and European Central Bank focus on banks’ asset quality will drive Italian banks to increase their coverage ratio,” PricewaterhouseCoopers said in a report on Oct. 21.

Capital Threshold

Raiffeisen Bank International AG, Austria’s third-biggest lender, said last month that souring corporate loans to large Austrian clients and an asset-quality review in Slovenia will cause provisions to rise as much as 20 percent this year.

The ECB said that banks will have to hold capital equivalent to 8 percent of their risk-weighted assets in the assessment. The central bank will use a more restrictive definition of capital when stress-testing balance sheets than it will to study their assets early next year.

While some investors considered that “a relatively easy pass mark,” given most banks exceed that level, “that’s missing the point entirely,” Morgan Stanley’s Ineke wrote. “We do not believe that it is possible to read anything into this capital threshold as being tough or lenient without knowing the results of the asset quality review.”

The ECB left unanswered questions on the conditions of the stress tests, including how much risk will be assigned to sovereign-debt holdings or the amount of capital banks will have to hold to absorb losses in adverse scenarios.

‘Challenge Ahead’

“The measures will only be transparent once we get the spread sheets and see how the ECB proceeds,” Gerhard Hofmann, a management board member at Germany’s BVR association of cooperative banks, said in a phone interview. “There will be banks that have a challenge ahead.”

The ECB included four banks represented by the BVR in its preliminary list of 124 firms, which is subject to change next year. The list comprises lenders with at least 30 billion euros in assets or which are otherwise deemed important enough to merit supervision.

Building capital has benefited some lenders as debt and equity investors reward companies deemed safe.

Credit default swaps on five-year senior debt issued by Stockholm-based Svenska Handelsbanken AB, Europe’s best capitalized major bank, trade about 54 basis points below those of London-based Barclays Plc, the least capitalized of 18 European banks tracked by Bloomberg Industries. A basis point is a hundredth of a percentage point.

Swedbank AB, the second-best capitalized bank, has jumped 31 percent this year in Stockholm trading, more than the 18 percent increase in the 44-company Bloomberg Europe Banks and Financial Services Index.

National ‘Backstops’

European Union leaders meeting in Brussels this week will call on the 17 euro-area countries to come up with a “comprehensive and coordinated approach” to prepare for the ECB-led bank assessments.

“It should involve all appropriate arrangements, including the establishment of national backstops” for lenders that struggle in the tests, according to an Oct. 23 draft of the summit’s conclusions obtained by Bloomberg News.

The last two drafts have omitted a reference to a “European approach” on backstops in an Oct. 14 version, highlighting the skirmishing on how centralized the EU’s approach to troubled banks should be.

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