Constancio Says Asset Review to Make ECB Stress Test Harder

European Central Bank Vice President Vitor Constancio said the fact that euro-area bank balance sheets will be probed before undergoing a simulated economic downtown later this year makes the test harder to pass.

“We have our own big add-on, in that we will integrate the results of the asset-quality review into the stress test, which will aggravate the results of the stress test,” Constancio said in Frankfurt today after giving an update on the ECB’s health check of the financial system. The ECB said the region’s largest banks will have to show their capital won’t fall below 5.5 percent of their risk-weighted assets in a crisis, matching stress-test parameters set by the European Banking Authority.

The Frankfurt-based ECB is conducting its yearlong assessment of lenders before taking over supervision duties for the euro area in November, in the first pillar of a banking union intended to prevent a repeat of the financial meltdown that almost splintered the currency bloc. ECB President Mario Draghi has said the assessment is key to bringing confidence back to the banking system and fostering the recovery.

“The objective is no more doubts about European banks,” Constancio said. “The balance sheet of European banks will be totally robust and transparent to all investors.”

Non-Performing Loans

Constancio argued that the 5.5 percent ratio is tougher than previous exercises, as it must be made up of the highest-quality form of capital, known as common equity tier 1.

The ECB had earlier backed setting the capital ratio at 6 percent of assets, according to two euro-area officials briefed on the matter. That position was prior to final agreement with the EBA, who are responsible for issuing stress-testing guidelines for the 28-nation European Union.

“We are talking about a common-equity threshold, it’s not Tier 1, which by itself is more demanding than any previous thing,” he said. “The strictness of the stress test can’t be measured by the threshold. It depends on the whole exercise, the extent of the shocks and so on. We can’t draw conclusions just from the threshold.”

The scenarios to be used in the stress test will be developed in coming months, and will be communicated to the banks by the end of April, Constancio said. Previous stress tests run by the EBA, which required a 5 percent capital ratio, foresaw a drop in output, a rise in unemployment and a fall in asset prices, and then mapped the effect against banks’ assets.

The ECB also outlined the definitions for non-performing loans in the second part of the assessment, known as the Asset Quality Review.

Level 3

The AQR is the second stage in the ECB’s Comprehensive Assessment, a review of bank balance sheets to identify any capital shortfalls. 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.

The chair of the ECB’s new Supervisory Board, Daniele Nouy, said today that the AQR is currently on schedule and that the central bank will conclude the portfolio selection stage by the middle of February.

“The methodology of the AQR comprises a number of different building blocks,” Nouy said. “Together these blocks provide a consistent, coherent and comprehensive approach to reviewing the asset quality of the selected portfolios.”

The ECB will also review Level 3 assets, which are the most-difficult to value assets for which banks have to assign their own models because they aren’t liquid, Nouy said.

“This will only be for banks with material Level 3 exposures,” Nouy said. “This is where the risk is the biggest, where the prices are not coming directly from the market.”

Government Debt

Bank holdings of sovereign debt, and their respective maturities, will also be disclosed in full, the ECB said. The central bank is working with national supervisors to finalize the methodology for the AQR and will release full details this quarter.

Constancio also said the ECB may allow banks to model the effect of selling certain loan portfolios on their levels of capital during the exams, rather than holding them to a so-called static balance sheet, which doesn’t take into account the actions of management in times of financial crisis.

“For instance, we may consider treating credit in a dynamic way instead of a static approach, as it is in the common exercise announced by the EBA,” Constancio told reporters in Frankfurt today.

The EBA said last week that national regulators could “analyze banks’ response functions and managerial actions for mitigating the impact of the stress test” to identify “measures for addressing possible capital shortfalls” shown up by the assessments.

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