ECB Stress Test Won’t Free Banks From Creditor Losses

Junior bondholders of European Union banks that struggle in a stress test this year won’t avoid losses if the lenders need government help, according to the bloc’s regulatory arm.

The test, carried out in the euro area by the European Central Bank, won’t allow banks to skirt EU policy on government assistance for banks, said Gert-Jan Koopman, the European Commission’s deputy director-general for state aid. ECB Vice President Vitor Constancio has said exemptions from the rules may be suitable for some banks shown to have capital shortfalls.

Under a law passed this year, governments can provide “precautionary” aid, without triggering resolution, to banks unable to raise funds privately after a stress test. Yet that won’t alter existing state-aid rules, which force losses on shareholders and junior creditors before public money can flow, Koopman said in an interview in his Brussels office.

“Precautionary recap is only relevant to a very limited number of cases, essentially where banks are not at the point of failing, but still cannot raise private capital,” Koopman said. “You’re outside of the resolution context, and the only thing that applies is state-aid rules, which basically then require burden-sharing. So they still require junior creditors to pay.”

As the ECB prepares to take over direct supervision of about 130 euro-area lenders from BNP Paribas SA to National Bank of Greece SA starting in November, regulators have sought to compile the toughest stress tests yet in a bid to repair credibility damaged by assessments in 2010 and 2011 that didn’t uncover weaknesses at banks that later failed.

Financial Contagion

Regulators are walking a tightrope, since the tests need to be tough enough to be credible, but not so tough that they set off another round of financial contagion.

“This bail-in situation for junior debt is complicated,” said Nicolas Veron, a fellow at the Brussels-based Bruegel research group. “It’s a challenge because state-aid rules go beyond what some member states are ready to do right now, and in addition to this it’s not clear the commission and the ECB see eye to eye on this.”

To pass the baseline scenario of the stress test, based on European Commission forecasts, banks have to be able to maintain a capital-to-risk-weighted-assets ratio of 8 percent. Under the adverse scenario, the ratio is 5.5 percent, and it assumes factors such as a drastic slump in home values, a surge in unemployment and plummeting economic growth compared with EU forecasts over the three years through 2016.

Baseline Test

Koopman said banks that come up short in the adverse scenario while passing the baseline test would be eligible for “precautionary” recapitalization without entering a full-scale resolution process, which is required for banks too sick to stay open.

“Precautionary recapitalizations can only be granted in a context of a stress-test environment, and only for losses that have not materialized or are not expected, so these are really exceptional cases,” Koopman said.

The ECB plans to release results of its Comprehensive Assessment, which includes an asset-quality review in addition to the stress test, in October. EU banks outside the euro area also will undergo stress tests overseen by the European Banking Authority.

The question of recapitalizing banks from the public purse after the ECB’s assessment is complicated by a law called the Bank Recovery and Resolution Directive, or BRRD, designed to make sure that taxpayers aren’t on the hook when lenders fail.

‘Disproportionate Results’

Much of BRRD will be in force from next year. Yet its tougher new bail-in rules covering senior bondholders won’t kick in until January 2016.

Until then, existing state-aid rules apply. They allow exceptions from forced creditor losses when this would “lead to disproportionate results,” in other words, if the public aid required is small compared with a bank’s risk-weighted assets, or if the financial stability is endangered.

The ECB’s Constancio said May 12 ‘‘it may be adequate’’ to invoke these exceptions after the Comprehensive Assessment.

His stance came under fire from members of the European Parliament, who say banks may be able to get bailouts and shield their creditors at taxpayer expense if aid is available. The EU’s competition division, which polices state aid, may face pressure from the central bank “to take a lenient interpretation of the conditions for preventative recap,” said Philippe Lamberts, a Belgian member of the parliament.

‘Full Light’

“They fear that if they do the health check of banks properly, zombie banks will come into full light and without preventative recap would be doomed to fail,” Lamberts said. “The ECB does not want this to happen.”

If aid is available to banks “considered healthy, but not that healthy,” it will signal that market discipline still doesn’t apply to the banking sector, he said.

ECB President Mario Draghi last year called on EU Competition Commissioner Joaquin Almunia, Koopman’s boss, to avoid an “improperly strict” interpretation of state-aid rules after the stress test.

In his reply, Almunia pointed to the exceptions provided in state-aid rules. Draghi said he was “satisfied” by the commission’s explanation.

Lenders from Italy’s Banca Monte dei Paschi di Siena SpA to Austria’s Raiffeisen Bank International AG have already completed share sales or plan them to strengthen their balance sheets. Constancio said that by the end of April, the region’s lenders had taken measures worth about 104 billion euros ($142 billion), including asset sales, convertible debt issuances and share sales.

Public Funds

For lenders that nevertheless face capital shortfalls after the ECB’s assessment, Koopman said partial measures won’t cut it. If banks opt for a voluntary debt-for-equity swap and fall short, this won’t entitle them to an exemption from further, forced losses before they can tap public funds.

Koopman also said nations ought to act soon to make sure their national laws comply with the new EU standards on handling failing banks. “Such changes may be easier to put in place when a country isn’t in a crisis environment.”

“We all know that burden sharing is a messy thing and it leads to litigation, so it is a lot wiser to preempt that, to take your time and get it right,” Koopman said. “If a member state said, ‘Listen we can’t do burden sharing because we don’t have the national legislation in place,’ then we’d say, ‘You have 48 hours to adopt it.’”

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