ECB to ask banks to maintain an 8% capital buffer

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The European Central Bank yesterday unveiled its plans for how it intends to review the balance sheets of euro zone banks, as it prepares to begin supervising banks for the first time.

The reviews, which will commence next month in collaboration with national authorities and will feed into the European Banking Authority's stress tests later next year, will "strengthen private sector confidence in the soundness of euro area banks and in the quality of their balance sheets," ECB president Mario Draghi said.

However, he warned that the availability of backstops was critical to the success of the project.

And he alsosaid that some banks need to fail the tests in order for the process to have credibility, raising the prospect of more public money being needed to bail out banks.

Capital threshold
Five Irish banks, including AIB and Bank of Ireland, will be subject to the assessment. According to analysts, the banks have a good chance of coming through the process given the lower capital threshold required, of 8 per cent of Tier 1 capital, compared with the 10.5 per cent needed under the Central Bank's prudential capital assessment review (PCAR) exercise.

European leaders meeting in Brussels today and tomorrow are expected to push for swift agreement on how to advance the euro zone’s plan for banking union, as well as discuss the necessary backstops to be used should next year’s stress tests reveal capital shortfalls, amid increasing divisions between member states on the issue.

Growing concern
While there has been growing concern that European rules on resolution will not be in place in time for the European stress test results, the timetable set out by the central bank yesterday suggests that the results of the ECB tests are still a year away and will be unveiled after the completion of the European Banking authority tests in November.

Banks would then be given time to raise the required funds, firstly through private sources. Under current state aid rules, junior bondholders and shareholders will then be bailed-in before the State and the ESM fund are tapped, though the precise bail-in hierarchy is still a matter of contention between euro zone member states, with suggestions yesterday that Germany may favour a bail-in of senior bondholders.

The “comprehensive assessment” by the ECB will encompass three parts – a supervisory risk assessment, an asset quality review that will examine the quality of banks’ assets, and finally a stress test which will look at the resilience of banks’ balance sheets in stress scenarios.

The rules will apply to 128 banks that will fall under the direct supervision of the ECB. All of these banks, regardless of their size, will be required to hold 8 per cent of Tier 1 capital, slightly higher than some analysts had expected, with banks permitted to apply transitional Basel III rules until 2019.

There had been some suggestions that banks would be requested to hold the equivalent in capital to 7 per cent of its risk-weighted assets, with an extra 1 per cent for the largest institutions. The asset quality reviews will also examine off-balance sheet positions and look at banks’ “sovereign and institutional holdings and corporate and retail exposures,” according to the ECB.

'Softer criteria'
The "long-list" of euro zone banks to be covered includes 24 German banks, 16 Spanish banks, 13 in France and 15 in Italy. Not all banks on yesterday's list may end up under the supervision of the ECB. According to a spokeswoman for the ECB, the bank "overshot" a little in compiling the preliminary list issued. A final list is to be published.

Euro zone bank shares fell amid fears that the tests could reveal substantial shortfalls. The IMF estimated earlier this month that banks in Spain, Italy and Portugal face about €250 billion in potential losses on their commercial loans over two years.