Don’t be distracted by the pass rate in ECB’s bank exams

For investors, the European Central Bank’s yearlong evaluation of the region’s banks isn’t just about who passes and who fails. The bigger question will be how much the ECB marks down lenders’ capital during its balance sheet inspection known as the asset quality review. The central bank and national regulators will publish their findings on October 26th.

“The focus will be on how the asset quality review influences the development of capital ratios and non-performing loans,” said Michael Huenseler, who helps manage about €13 billion, including European banking shares and bonds, at Assenagon Asset Management SA in Munich.

The largest impact may be on Italian lenders led by Banca Monte dei Paschi di Siena SpA, Unione di Banche Italiane Scpa and Banco Popolare SC, according to a report last month from Mediobanca SpA analysts. They foresee a gap of more than 3 percentage points between the capital ratios published by the companies and the results of the ECB's asset quality review.

Deutsche Bank AG may see its capital fall by €6.7 billion, cutting its ratio by 1.9 percentage points, the analysts said.

Officials for the four banks declined to comment. The biggest publicly traded lenders may see their combined capital eroded by about 85 billion euros in the asset quality review because of extra provisioning requirements, according to the Mediobanca analysts, led by Antonio Guglielmi. That equals a reduction of 1.05 percentage points in their average common equity Tier 1 ratio, the capital measure the ECB is using to gauge the health of the banks under study, the analysts said.

Capital gap

The AQR evaluates lenders’ by scrutinising the value of their loan books, provisioning and collateral, using standardized definitions set by European regulators. To pass, a bank must have capital amounting to at least 8 per cent of its assets, when weighted by risk. The bigger the hit to their capital, the more likely lenders will need to take steps to increase it. Banks the ECB will supervise directly already bolstered their balance sheets by almost 203 billion euros since mid-2013, ECB President Mario Draghi said this month, by selling stock, holding onto earnings, disposing of assets, and issuing bonds that turn into equity when capital falls too low, among other measures. “Investors will concentrate on the discrepancies between what banks have announced and the review’s results,” said Mario Spreafico at Schroders Private Banking for Italy. “These gaps will affect banks’ valuations and market expectations for the actions they may take.”

Lending needed

Paschi and Banca Carige SpA, two of 15 Italian lenders in the review, are set under the tests’ most-severe scenario to face capital shortfalls they’ll need to plug, a person with knowledge of the matter said. The pair are unlikely to have raised sufficient capital this year to fill the shortfall and will probably have to find fresh funds, said the person, asking not to be identified because the matter is private. Spokesmen for Paschi and Carige declined to comment on such an outcome. If European banks have a deep capital hole, it will make it more difficult to increase lending and help pull the region’s economy out of the doldrums, a key objective of the ECB. At the same time, inspections viewed as too gentle by investors threaten the credibility of the central bank as it prepares to become the supervisor for euro-area lenders next month.

Right impression

“The conflict of interest is obvious,” said Daniel Hupfer at M.M. Warburg in Hamburg. “At the moment I have the feeling the ECB’s making the right impression -- serious, but not too strict.”

The Euro Stoxx Bank Index fell 5.2 per cent in October, in part on concern Europe's economy may slip into its third recession since 2008. The index rose 0.5 per cent by 10:42 a.m. Frankfurt time today. In its exercise, known as the comprehensive assessment, the ECB combed through the books of about 130 of the largest banks to ferret out bad loans, while seeing whether the lenders can withstand hypothetical economic shocks in stress tests. Barclays Plc analysts, in a note last week, identified eight lenders they see as less likely to pass the comprehensive assessment, including Austria's Raiffeisen Bank International AG, Portugal's Banco Comercial Portugues SA, Banco Popular SA of Spain and German shipping lenders HSH Nordbank and NordLB. Officials at the banks declined to comment on the exams.

‘Major issues’

A passing grade in the stress test requires capital of 5.5 percent of assets weighted by risk. “While the stress tests are based on highly unlikely future events, the asset quality review is a real audit of the banks, and therefore it will be the focus of results,” said Carlo Alberto Carnevale Maffe, professor of business strategy at Milan’s Bocconi University. Firms will have six months to raise equity to cover shortfalls identified in the AQR or the milder of two stress- test scenarios, and nine months to fill capital holes resulting from the tougher scenario. Deutsche Bank, Germany’s largest lender, is at risk of failing the stress test based on its financial standing before it sold shares to raise capital this year, said analysts at Bankhaus Lampe and Bankhaus Metzler. Even so, an €8.5 billion stock offering in the second quarter will probably cover any shortfall identified in the test, which is based on the bank’s 2013 accounts, the analysts said.

Easier comparisons

Questions remain over how the findings will be implemented. For companies passing the asset quality review, it’s still unclear how the deviation between their stated and post-AQR figures will be treated in their balance sheets. “We need to know whether banks have to reclassify accounts rectifying the value of their books to take into account the different valuation made by the central bank, or if they can simply add a line at bottom with the adjusted core capital figure as happened with the previous stress tests,” said Fabrizio Bernardi, a Milan-based analyst at Fidentiis Equities.

In either case, the assessment will provide more information on lenders’ finances than previous exams and uniform criteria and methods should make it easier for investors to make their own comparisons between firms in different countries, according to Steve Hussey, an analyst at AllianceBerstein in London.