ECB Hosts Day One for Supervisors on Bank Union Path

The first pillar of Europe’s banking union is taking shape.

The European Central Bank’s new Supervisory Board, tasked with overseeing the euro area’s biggest lenders, will hold its inaugural meeting today in Frankfurt. The watchdog is another step toward the more-integrated, more-stable banking system dreamt up by European Union leaders at the height of the debt crisis as a way to prevent a repeat of the financial meltdown that almost splintered the currency bloc.

Over the next 10 months, the board’s chairwoman, Daniele Nouy, must ensure an asset-quality review is seen as tough enough to uncover the banking system’s weakest links and build a supervisory architecture to monitor lenders from Deutsche Bank AG to UniCredit SpA. As staff fit out office space and sift applications for 1,000 new recruits, the complexity of the task -- from agreeing on a definition for bad debt to plugging capital holes -- is only now becoming evident.

“This is a very short space of time in which to create a level playing field, so it’s not going to be perfect,” said Bridget Gandy, managing director for financial institutions at Fitch Ratings Ltd. in London. “The AQR will be considered to have failed if the ECB doesn’t fail some banks.”

Unfilled Positions

The AQR is the second stage in the ECB’s Comprehensive Assessment, a review of bank balance sheets to identify any capital shortfalls before it officially becomes the region’s supervisor in November. The first phase identified which assets from government debt to mortgages and shipping loans should be studied, and the third and final stage will be a stress test to see if lenders can survive a downturn. The results will be published before oversight formally starts in November.

The Supervisory Board will help carry out the assessment and, after November, will prepare all decisions on oversight matters. While ECB President Mario Draghi isn’t involved in the board’s daily work, he will have a say on its recommendations as the head of the central bank’s decision-making Governing Council.

Nouy, 63, will meet with the national supervisors of the 18 euro-area countries today, a ECB spokeswoman said. Still to join the team in a spartan, temporary office in Frankfurt’s Japan Tower a short walk from the current ECB building are the vice chair, nominated to be Executive Board member Sabine Lautenschlaeger, and four officials from the central bank. The immediate concern is likely to be how to make the AQR credible.

Capital Raising

“If this test isn’t being regarded as a serious exercise that finally brought clarity about the European banking system, if it does not establish that opinion, Europe has a huge problem,” Andreas Treichl, chief executive officer of Austria’s Erste Group Bank AG, said in Brussels on Jan. 27.

While teams of auditors and supervisors prepare to be sent to bank premises for on-site examinations of the balance sheets, some lenders are already acting to make sure they won’t be found short.

Austria’s Raiffeisen Bank International AG and Italy’s Banco Popolare SC have already announced share sales this year, following capital raisings by Banco Popular Espanol SA, Banco de Sabadell SA, Bank of Ireland and Erste Group in the second half of 2013. Popolare and Sabadell are among banks that have lifted provisions for loan losses, along with KBC Groep NV, Deutsche Bank AG and Intesa Sanpaolo SA.

Banco Santander SA, Spain’s biggest bank, said today that profit more than doubled on lower provisions for bad loans. Earnings rose to 1.06 billion euros ($1.44 billion) from 423 million euros a year earlier, the Santander, Spain-based bank said in a filing to regulators today.

Bad Debts

European banks have strengthened their capital base by about 80 billion euros since 2011, Olli Rehn, the EU’s economic and monetary affairs commissioner, told reporters this week in Brussels.

The auditing task is made harder by the financial system’s complexity. In an internal document written in late 2013, the ECB said that the variety of practices for classifying bad debt, or non-performing loans, could make the assessment meaningless if they aren’t taken into account. A too-simple definition may not reveal the true extent of bad loans on the region’s books.

“A more ambitious definition would be consistent with the need to convey to external observers that the AQR is a thorough exercise,” the ECB said.

“There is so much heterogeneity in the euro-area banking sector,” Michael Kemmer, general manager of the Association of German Banks, said in Frankfurt on Jan. 15. “The trick now is to find a way through that which is not so prescriptive as to be unworkable, nor so general and lax as to be meaningless.”

Backstop Risk

The ECB doesn’t have much time to build the institution-within-an-institution that will be the financial sector’s overlord. EU leaders agreed on a banking union in June 2012. If officials take up supervision as planned, they’ll have achieved the task in less than half the six years needed to set up the ECB’s monetary-policy structures from 1992 to 1998.

The central bank will directly oversee about 130 of the euro area’s largest lenders, with the remaining 6,600 in the currency bloc staying under the day-to-day observation of national authorities. The exact division of labor is still being worked out, with a “framework regulation” due to be sent for public consultation next month, an ECB spokeswoman said on Jan. 28.

The ECB says it won’t be deterred by the difficulty of the task, nor by the lack of clarity on whether a Europe-wide government backstop will be available this year if lenders can’t fill capital needs in the financial markets.

ECB Credibility

A handbook for staff conducting on-site inspections will be readied during February, and Nouy will give her first progress report to the European Parliament in Strasbourg on Feb. 4.

While Dutch Finance Minister Jeroen Dijsselbloem said last week that direct recapitalizations from the euro area’s bailout fund will be ready for banks following the asset-quality review, ECB Vice President Vitor Constancio said on Jan. 27 he assumes that tool won’t be available.

“The ECB will not put its reputation at risk,” Constancio said in Brussels. “The credibility is to do with the methods and the credible implementation. Whatever is found is found and will be disclosed.”

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