ECB’s first flight in Eurozone’s banking universe will be just a reconnaissance

Press conference by Michel Barnier, Member of the EC, on the establishment of a Single Resolution Mechanism for the Banking Union. (EC Audiovisual Services).

The European Central Bank, in view of its new role as single supervisory authority of Eurozone’s banking system, a task that will officially commence in November 2014, is now testing the grounds of this real banking constellation, which comprises a round number of 6000 banks. The ECB will undertake with its own proper mechanism the supervision of the ‘significant’ credit institutions, with assets of more than €40 billion, that is approximately 130 financial firms accounting for around 85% of euro area’s banking system. The rest of the lenders will be supervised by national central banks, under ECB’s guidance.

However, in view of the problems which currently infest Eurozone’s banks, ECB first wants to test the grounds of this unexplored galaxy, with a twelve month ‘comprehensive assessment’, starting as from next month and planned to be concluded in October 2014. This assessment is an essential element of the preparations for the Single Supervisory Mechanism, providing the necessary clarity on the banks that will be subject to the ECB’s direct supervision which are around 130 financial firms. The SSM Regulation which foresees all that, comes into force in November 2013.

A demanding exercise

The exercise will comprise a supervisory risk assessment, an asset quality review and a stress test. According to ECB “The integrated outcome of the comprehensive assessment may lead to a range of follow-up actions, possibly including requirements for changes in a bank’s provisions and capital”. This is exactly where the problems begin.

Eurozone banks suffer from a combination of a super inflated investment portfolio and a growing package of bad loans. Both those illnesses get worse due to the general economic downturn. Banks’ assets are constantly loosing value, while the on-going misery in many countries, forces households and SMEs to fail servicing their debts. Both those diseases call for more good quality capital, if the lenders are to maintain their capital adequacy at the levels demanded by the relevant EU rules.

After the financial crisis broke out in 2008, a large number of major banks were forced to seek protection from governments. More than €275bn of taxpayers’ money has been injected to support euro area banks’ capital. Some of them managed to raise capital from their shareholders. According to ECB, “Since the onset of the global financial crisis, euro area banks have raised around €225bn of fresh capital”.

Half a trillion not enough?

This is not peanuts. Half a euro trillion is the equivalent of 5% of Eurozone’s GDP. Given that, ECB insists that this is enough. A relevant text on its site says, “Today, the median Core Tier 1 capital ratio of the largest euro area banks stands close to 12%, and most of these banks comply already with the minimum regulatory capital requirements of the fully implemented Capital Requirements Directive IV/Capital Requirements Regulation (CRD IV/CRR) framework”.

This passage is very carefully written. For one thing, it doesn’t say all the major Eurozone banks. Not a word for the rest of the lenders. In any case if this 12% Core Tier 1 capital ratio was true, then why have the lenders stopped lending in many Eurozone countries? The banks absorb the abundant liquidity offered to them by the ECB at 0.5% and keep it in their coffers. Actually, the total of outstanding loans is decreasing in Eurozone.

In short, if this 12% of capital adequacy was true, everybody would have been happy. Unfortunately it’s not. That’s why the ECB, in its note on this comprehensive assessment, clarified that the minimum capital adequacy threshold to be used in this exercise will be 8%. This said, the next issue that arises is the quality of capital to be included in this 8%. As every first year student of economics knows, bank balance sheets are real minefields. With the globalisation of the financial system it will be difficult to distinguish what is real capital and what is borrowed money. Lenders may very easily appear as shareholders. Let alone that banks do favours to each other and help their peers with short term money injections dressed as capital.

Of course the ECB is aware of all that. That is why it notes that “weaknesses remain, compounded by the perception that banks’ balance sheets are not transparent and concerns about their overall risk situation”. In this passage, ECB wants to stress that it is aware of what is going on in the banking industry and tries to appease the widespread public anger against the banks.

As noted above, though, the banks have the ability to use the entire world as their hiding place and it is impossible, under the present ‘laisser passer’ conditions, to any supervisor to reach the core capital. In view of that, there is a widespread feeling that this initial ECB’s reconnaissance flight in the banking constellation during the next twelve months will be of a training character. Of course, the central banks will not accept to cover possible ‘tigers’ lurking in the banks’ basements.

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