The ECB Asset Quality Review

 

WEEKLY COMMENT 30-10-2014

By Barry Edwards

The ECB Asset Quality Review

The European Central Bank (ECB) instigated the Asset Quality Review (AQR) in March 2014 as part of the comprehensive assessment of the largest banks in the Eurozone; this is a major step forward to the operational start of the Single Supervisory Mechanism (SSM) on the 4th of November 2014; it is the name given to the process of regulating the biggest banks. A quote from the introduction to the report states ‘’It constitutes an exercise of unprecedented scope, and the publication of its outcomes provides a significant improvement in the depth and comparability of the information available on the condition of the 130 participating banks’’. The full report was released last weekend; it contains 178 pages of detail which you can look at if you click on the link below. It is worth reading the executive summary which is only 3 pages;

https://www.ecb.europa.eu/pub/pdf/other/aggregatereportonthecomprehensiveassessment201410.en.pdf

The ECB identified 25 banks as having been undercapitalized as of end-2013; of these, 12 have raised enough capital this year to be technically compliant with capital requirements, but the other 13 need to submit recapitalization plans to the ECB within two weeks. In total, the assessment identified slightly more “problem banks” than expected but did not uncover problems so massive that they may trigger systemic instability. Overall, the comprehensive assessment identified a capital shortfall of €24.6 billion across the 25 banks after comparing the projected solvency ratios against the thresholds defined for the exercise; this is explained in the executive summary at the beginning of the report.

The purpose of all this is to establish the basis for the ECB to become the bank regulator for the 130 largest banks similar to the new arrangements implemented for the Bank of England. From the 4th of November the ECB will be able to make sure all these banks conform to the rules that have been painstakingly passed by the European Parliament over the last 5 years. This new regulator is for the biggest banks and all the other banks in the Eurozone will come under the jurisdiction of their national central banks.

Many economists and financial commentators are fairly sceptical of this review and believe that the new Basel 3 minimum capital requirements that will form the basis for all banks worldwide, which comes into force in 2019, would show many other banks are undercapitalised in the EU; a much higher figure than the AQR identifies (€100’s of billions). However, everyone agrees that it is better to have started the process than not do it at all and now the ECB controls the regulation, confidence in the reliability of the balance sheets will be greatly enhanced.

Basel 3 is the framework for bank capital proposed by the Bank for International Settlements (BIS) which is the central banks’ organisation, 60 countries are members and it sets out the framework that commercial banks should adopt as the recommended capital basis for operation. Basel 3 is currently still being finalised and the previous Basel 1and 2 were accepted as the structure all banks should follow. Basel is the town in Switzerland where it is based.

The above is a very brief summary but the main point of describing the work being done is to show it is of great concern to all countries not just the EU. The main purpose of the grand plan is to avoid banks being a burden on taxpayers if they fail and affecting the world financial system. Although it is a big comfort to know that banks will be properly capitalised and sound, many commentators are doubtful it will solve the growth problem being experienced in Europe and other parts of the world where companies not able to access stock market or bond funding have traditionally been financed by banks.

The reasons for this doubt are that the new rules being imposed require banks to hold much more capital to support their lending to the small and medium sized corporate market as well as the lack of growth in the EU economy and little demand for finance from SME’s. There is a real need for a different approach to solving this lack of funding which will only partly be satisfied by alternative finance and packaging up asset backed lending into bonds which we have mentioned previously in these comments. Many countries understand this dilemma and have government sponsored organisations to help fill the gap but they only partly solve the real needs of the SME market.

It would be far better if private organisations were encouraged to evolve that could be the link between SME’s and the banks where the government support that is available is also processed, mostly by the banks. In effect these organisations would advise, support and arrange the funding of all kinds and the banks simply provide the low risk finance mainly working capital for growth. Other professional specialist investors and lenders would provide the high risk equity and loans while the whole package is coordinated by these new organisations. They would be able to make sure that all businesses they support have the right advice and would resolve problems when they arise. It would be a simple procedure for these organisations to provide a rating service and detailed information about the companies that would encourage institutional funding into the market.

Senior financial managers rarely get involved in SME activity and most do not understand the intricacies of helping this sector, consequently governments never get the message that a different approach should be encouraged. The attempts by government to have a real influence are usually poorly funded and have little impact on the market. The expertise for SME’s is available, professional and the people are willing to participate in a truly comprehensive package that could make that real difference, it is time government got behind a new approach especially when it can be done without burdening the hard working and long suffering taxpayer.

It is apparent we are moving into a new political phase where no one party is likely to dominate government, the attraction of a very low cost scheme should have great appeal and improve the politicians standing with the public. Since the SME sector is the real engine of growth in the economy, it must be worth a try.

That’s all for this week, more observations next week.