Mersch Says ECB May Target Banks’ Vulnerabilities in Stress Test

European Central Bank Executive Board member Yves Mersch said tests on the robustness of Europe’s banks will likely use known weaknesses in the financial system as a starting point.

“Probably, for the stress scenario, the so-called vulnerabilities will be envisaged as shocks, that then form part of the conventional macro-models,” Mersch, who is one of two ECB board members responsible for helping to implement a European banking union, said in a speech in Berlin today. “It hasn’t been decided yet how high the capital requirement for the stress scenario will be.”

The Frankfurt-based ECB said last week that euro-area lenders still face souring loans as a result of economic weakness, tensions related to sovereign debt and nervousness in bank funding markets. As part of an overhaul of Europe’s financial architecture, the ECB is checking the health of about 130 banks in the region before taking over supervision of them next year.

“It’s decisive that this stock-taking exercise creates transparency, is credible, and brings back trust in European banks,” Mersch said.

Comprehensive Assessment

The third part of the ECB’s Comprehensive Assessment is a stress-test exercise that’s being prepared in cooperation with the London-based European Banking Authority. Details of the methodology are due to be released at the end of January 2014.

Mersch said the test will have a basis scenario, oriented on the European Commission’s spring economic forecasts, and a stress scenario that pits bank balance sheets against an imagined worsening of the economic environment.

He outlined basic parameters such as the 3-year time frame of the tests, along with the capital definition to be used, on Nov. 18. How hard the ECB will stress holdings of government bonds on bank balance sheets has yet to be decided.

“We’re still working on the details,” he said today.

Italian banks, such as Intesa Sanpaolo SpA and UniCredit SpA are paring their holdings of sovereign bonds in anticipation of the ECB review. Banks’ holdings of Italian debt, which almost doubled in 18 months to a record 401.7 billion euros ($545.4 billion) in June, declined 2 percent in the third quarter, Bank of Italy data show.

Financial Stability

“While conditions in euro-area sovereign debt markets have indisputably strengthened over the past year, there remains a risk of renewed tensions on account of low growth and a slow implementation of reforms,” the ECB said in its Financial Stability Review on Nov. 27.

The setting of a capital requirement for the stress scenario in the tests will depend on the extremity of the theoretical situation, Mersch said. 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.

“This is about a forward-looking view of the resistance capacity of the banking sector under adverse conditions,” Mersch said. “We are currently agreeing on these details internally.”

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