Participation of Olli Rehn, Vice-President of the European Commission, in the EC/ECB joint conference on Financial Integration and Stability. Ignazio Angeloni, Director General of DG “Financial Stability” of the ECB, Jonathan Faull, Director General of DG “Internal Market and Services” of the EC, Nadia Calviño, Deputy Director General of DG “Internal Market and Services” of the EC, and Olli Rehn, at the podium (from left to right). (EC Audiovisual Services).
While the whole world knows that the Eurozone banks are very short on truly own capital and their overall leverage ratio is less than 3%, the European Central Bank avoids analysing in detail the exact magnitude of this crucial indicator. In its Banking Structure Report, which was published yesterday covering the period 2008-2012 and the first half of this year and spanning 50 pages, the ECB didn’t find the courage to report on that. In reality, Eurozone banks have ‘invested’ almost 33 times their capital, of which the 32 times correspond to other peoples’ money. They only hold €3 as capital every time they lend or ‘invest’ €100 borrowed money.
The authors of the report at the very end simply observe that the “leverage ratios of large euro area banks still tend to be lower than those of their US peers, even on a comparable International Financial Reporting Standards (IFRS) basis”. They add, though, that this is “especially the case for euro area banks with large or significant investment banking activities, including sizeable derivatives portfolios”. Thank God at the end they at last dared tell the truth, that the balance sheets of the large Eurozone banks are full of risky if not toxic investments, five years after the 2008 crisis.
Three times the GDP
At the very beginning of this report the ECB states that Eurozone banks’ assets reached €29.5 trillion at the end of 2012, or 12% less in comparison to 2008. This is three times the GDP of the single money zone, with the German and French banks accounting for almost half of it, at €7.6 trillion and €6.8 trillion, respectively. The three largest Eurozone banks Deutsche Bank, Crédit Agricole and BNP Paribas holding between them €7.6tn in assets. Neither Germany nor France can rescue those lenders if they fail.
The careful reader of this ECB publication should keep this in mind, while going through it. Not to forget that ECB itself was obliged to acknowledge that the large euro area banks hold “sizeable derivatives portfolios”. This is a timid way of telling everybody, that it is almost impossible to assess the risks hidden in this quite unpredictable financial universe. In other words the authors of the report couldn’t avoid acknowledging that Eurozone’s banking system is exposed to unknown risks. The bankruptcy of Detroit revealed that many Eurozone banks had an appetite for risky placements in US municipal debt.
A solid beginning
However, in the first lines of the report the ECB wanted to give the impression that it is overseeing on a solid banking system. It says “In aggregate, the median Tier 1 capital ratio (own capital) in the euro area increased from 8% in 2008 to 12.7% in 2012”. Mind you, this is the median not the arithmetic mean. The median is that value in a distribution which separates it in two halves and represents better the two extreme values of it (outliers). In this case, the arithmetic mean would have been a better approximation of reality because it’s not dragged to the extremes.
Even better though, the ECB could have used the two aggregates and simply put them in a fraction – capital over assets – and simply given us that percentage. But, yet again, it seems it’s too early to tell what is capital and what is not. In reality, this will be the essence of ECB’s supervision over the 130 largest Eurozone banks as from November 2014, when its mandate starts. Before that, the ECB will run a “comprehensive assessment” during the next twelve months concluding in October 2014, in order to test the ground of Eurozone’s real banking constellation.
Avoiding the leverage test
Banks, in order to avoid an in-depth audit on their entire balance sheet, discovered the risk weighted assets (RWA) exercise. They attach a certain risk element to each category of assets and, in this way, they calculate their RWAs. This exercise is performed in order to assess the Capital Adequacy Ratio of a lender. The problem is, though, that it’s the banks themselves that attach their assets to each risk category. Without an in-depth audit it’s impossible to arrive at a reliable assessment of capital adequacy ratio. On top of that, banks usually hold large off-balance accounts where it is very difficult to identify the real exposure to risks. Applying the RWA method to those accounts is even less productive.
Obviously the most reliable way to assess a bank’s trustworthiness is to accurately estimate its own capital and compare it with its assets. In reality, this is not a difficult exercise at all. Very simply, own capital is what the bank has received from shareholders plus what is withheld as reserve from annual profits. However, it seems that this simple exercise will expose very unpleasant things and that’s why it is avoided.
In any case the ECB would have a very difficult task in supervising this real jungle of Eurozone’s banks. The US and the Swiss lenders are much more strictly controlled by regulators. The problem is that in Eurozone the banks are doing also the work of the capital markets, unfortunately in a less transparent and competitive way.
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