12 November 2013

Notes on ECB’s Comprehensive Bank Assessment (Part 1)

Next year in the same time we are supposed to know the truth about the balance sheets of large European banks. Namely, the ECB is planning to conclude the comprehensive assessment of the euro area’s banking system in October 2014, prior to assuming its new supervisory tasks in November 2014. Will it be an honest estimate or yet another failed attempt to convince someone (stakeholders) in the soundness of banks – failed like the previous stress tests failed?

Whatever the exact outcome, the ECB’s comprehensive bank assessment is going to be the main thing to watch over the next 12 months in European banking. In the series of articles “Notes on ECB’s Comprehensive Bank Assessment”, I intend to summarize my observations, notes and opinions on the topic. The first piece will be about the details announced on 23 October 2013. I shall begin with an overview of the current state of affairs, though; context is important. The topic itself will be more thoroughly discussed starting from Part 2.

   
Obviously there just have to be strong motives for carrying out an exercise, the comprehensive bank assessment, which will take no less than 1.6 million extra working hours of supervisory resource (800 new people working intensely for a year) plus whatever the Oliver Wyman’s consultancy services might cost plus a number of expensive hours of bank CEOs, CROs and CFOs – not even mentioning the banks’ technical and analytical staff. And there are.

Underlying rationale of the initiative in the accompanying note to the 23 October press release is provided in very soft language, I’d say. They are talking about the economic downturn and financial market stress which has impacted banks’ balance sheets, with negative consequences for lending to the real economy. They are pointing out the overall perception that banks’ balance sheets are not transparent, and concerns about the banks’ overall risk situation. (Note the word “perception” – if it’s a perception, it’s a well-founded one.) They are leaving the audience with an impression that the exercise is going to provide transparency, identify and implement the necessary corrective actions, and build confidence – and everything under the supervision of the ECB.

Data, figures and revelations in a number of other publications by the IMF, Bank of International Settlement, the European Systemic Risk Board (ESRB) and the European Banking Authority (EBA) as well as the speeches given by some of the so-called institutional bankers are pointing to a much harsher reality, however.

It turns out that the very people and organizations who are supposed to be in charge of financial stability appear to have no reasonable idea whatsoever about the proper value of the assets and liabilities in the banks’ balance sheets. Nor can they rely on the banks’ calculations of the risk-weighted assets and the regulatory capital ratios. They only seem to have a bad feeling that the hole must be big; they know that banks’ risk calculations probably do not reflect the underlying risk profiles.

Thus, as of now they are not able to convince financial market participants and banks’ stakeholders in the trustworthiness of the European banks either. In other words, the comprehensive bank assessment together with the follow-up actions is ought to save the day for the banking supervisors and –regulators. There is so much truth in what the ECB Executive Board member Joerg Asmussen is reported to have said: “This is our third and last chance to restore confidence.”

Let me elaborate on the current situation a bit more.


Here is an illustration of the banks’ price-to-book ratios in Europe and in the US:

 

While bank stocks in neither side of the Atlantic are nowhere near the pre-crisis levels, market values of the European banks are considerably lower than their book values. Yeah, European banks appear now relatively cheaper than the US banks were in the aftermath of Lehman Brothers collapse. In other words: financial market participants do not believe that the banks are worth what they are reporting they are.

In the October 2013 Global Financial Stability Report (GFSR), the IMF staff assessed the scale of the current corporate debt overhang (measured as the share of corporate sector debt with an interest coverage ratio of less than 1) in Europe and first of all in Portugal, Spain, and Italy. They came out with what I’d think of as pretty crazy figures (to gauge the scale of the debt overhang on a forward-looking basis, two scenarios were defined: Chronic-phase scenario and Reversal-of-fragmentation scenario):


So in the “stressed countries”, 45-55% of total corporate debt is to the so-called zombie companies that need constant bailouts and additional financing in order to operate … The average of the core Europe, France and Germany, (15-18%) is nothing to be proud of, either.

But a debtor’s problem is a creditor’s problem as we know all too well. In Europe where the financial system is largely bank-based, zombie companies are the problem of banks. If debtors and creditors have problems, borrowing and lending activity stops which means that due to the accumulating interests, there is simply not enough money in the system for paying back the existing debts. And of course, if banks and the governments are in a lethal embrace as they are, weak banks can sink governments (other way round is true as well).

Obviously, governments are trying to do something. So, as a careful reader can read from the very same October GFSR:
“Some policies have tolerated or encouraged forbearance on loan payments by distressed firms, which could lead to the practice of “evergreening,” whereby banks delay or fail to recognize loans as nonperforming.” 
Specifically, such policies are reported in Italy – but I’m pretty sure that they are present in other countries as well.

Anyway, the result is that the European level regulators do not know how many forborne exposures and de facto non-performing loans there are in the banks’ balance sheets. “Evergreened” loans simply do not appear as impaired loans in the accounting figures and/or as defaulted exposures in the regulatory numbers.

When discussing the recent proposal of the European Banking Authority (EBA) for non-performing exposures* with the industry, the EBA among others states:
“…supervisors cannot rely only on disclosures based on internal definitions used in the risk systems of institutions to carry out their duties…”
It explains in more detail issues related to the consistency of asset quality assessment across the EU (different jurisdictions are drawing different lines between the performing and non-performing exposure categories) as well as uncertainties surrounding delaying loss recognition and masking asset quality deterioration. My main take-away is that current accounting and regulatory figures are unreliable – or at least not reliable enough for the financial supervisors. But then: why should investors, creditors, depositors and tax payers believe the numbers reported by the banks?

There is a reason why non-performing exposures are not and cannot be easily written off: obvious undercapitalization of the entire banking system and the so-called systemically important banks in particular. Indeed, as illustrated in the Figure below, the results of the EBA Basel III monitoring exercise as of end 2012 (published in 25 September 2013) reveal that despite of large European banks reporting fairly sound capital ratios (weighted average is close to 9% even assuming full implementation of Basel III), their weighted average leverage ratio, i.e. tangible capital divided by total exposure, is just 2.9%.


2.9% – less than 3 cents of capital per each euro of risk exposure – and this in an economy where a large share of borrowers is hanging between life and death! Quoting a paragraph from the remarks by FDIC Vice Chairman Thomas M. Hoenig to the International Association of Deposit Insurers 2013 Research Conference (“Basel III Capital: A Well-Intended Illusion” – informative piece, by the way):
“We learned all too late [from the U.S. sub-prime crisis] that having less than 3 cents of tangible capital for every dollar of assets on the balance sheet is not enough to absorb even the smallest of financial losses, and certainly not a major shock.”

But the fact of banks being undercapitalized is perhaps even not the most important. It’s more important that the root cause which has provided justification for this, the sophisticated framework for calculating regulatory capital ratios known as Basel II/III, is still there and well. There might be nothing wrong with it if the risk-weighted assets (RWAs) were estimated – or even possible to estimate – properly. Unfortunately that’s not the case.

Mr. Hoening brings some examples in his speech, including this one:
“For example, in the fourth quarter of 2012, Deutsche Bank reported a loss of 2.5 billion EUR. That same quarter, its Tier 1 risk-based capital ratio increased from 14.2 percent to 15.1 percent due, in part, to “model and process enhancements” that resulted in a decline in risk-weighted assets, which now amount to just 16.6 percent of total assets.”**

He is not the only one who is drawing attention to the banks’ on-going efforts to manage reported risk assets down, no matter the risk. Indeed, also the reviews on the consistency of risk weighted assets by the EBA in Europe and by the Basel Committee on Banking Supervision on global scale have basically confirmed market suspicions about considerable variation across banks in average RWAs that do not necessarily reflect differences in underlying risk profiles.

Specifically, the EBA observed the following variations in the global charge (defined as [RWA plus 12.5 times expected loss] divided by the exposure at default (EAD)) for the European banks:


It found that half of the variance derives from the factors other than IRB risk parameters, and another half is directly stemming from the IRB risk parameters. Both types of difference are only partly justified. For example, the different supervisory practices in implementing Basel II/III are likely to get a lot more attention.

More interestingly, the EBA staff among others asked a sample of 35 IRB banks (banks applying internal risk models in credit risk calculations) from 13 EU countries to assign PD (probability of default) and LGD (loss given default) estimates, risk weights, expected losses (EL) and some other parameters to a set of identical real common counterparties, assuming the same hypothetical exposures (senior unsecured loans). While LGD estimates were mostly very close to the regulatory figure for Foundation IRB (45%), internal PD estimates varied quite a bit:


Still, the conclusion of the review is pretty inconclusive:
“This report identifies, however, the existence of variation in EL and RWA by exposure across banks even when the analysis is conducted on hypothetical identical exposures to the same counterparties. The comparative analyses conducted with the benchmarking portfolio exercise, to be considered carefully because of their intrinsic limitations…”
In what extent variations in risk estimates are justified? We don’t know – and the EBA staff sounds unsure about the research findings.

It’s odd though that ca. 40% of the large banks in Europe are effectively claiming having a very low risk profile as reflected in their leverage ratios at around or below 3%.

 
In the light of the above, I wonder what could possibly be the conclusions of the stress test that forms the third pillar of the ECB’s comprehensive bank assessment… Obviously, the European banking system as a whole would not survive any reasonable stress test when done properly.

We shall see… I’m waiting with interest. My expectation is that we are going to observe at least some degree of hmm… smartness both in calculations and in communication.


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* EBA FINAL draft Implementing Technical Standards On Supervisory reporting on forbearance and non-performing exposures under article 99(4) of Regulation (EU) No 575/2013
** It is to be pointed out that Deutsche Bank has been skillful in manipulating the leverage ratio as well: as of 30 June 2013, its self-reported leverage ratio was 3% while the IFRS estimate stood below 2%.

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