The asset-quality review: Close scrutiny of Europe’s banks may turn up unexpected shortfalls

The asset-quality review: Close scrutiny of Europe’s banks may turn up unexpected shortfalls

Oct 5th 2013 |From the print edition

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THE ink on the agreements that will hand supervision of the euro area’s biggest banks to the European Central Bank (ECB) is barely dry. Yet the ECB is already enmeshed in squabbles with national banking supervisors over the extent of its powers and the rigour with which it will undertake its first big task, a warts-and-all review of the balance-sheets of the banks it will take charge of in a year’s time.Details over how the ECB will conduct this asset-quality review (AQR) will probably be released in the second half of October, but the outlines are already beginning to emerge. The main aim of the review is to ensure that the ECB is not embarrassed by the revelation of holes in the balance-sheets of its new charges. Fresh in its mind is the example of the European Banking Authority (EBA), a young European regulator that lost much of its credibility after the collapse of banks that had passed its stress tests only months earlier.

To avoid that danger the ECB is emphasising that the AQR is not a stress test, which would simulate the effect of various economic scenarios on banks’ balance-sheets. Instead it is doing a preliminary examination to ensure that it understands what is on banks’ books in the first place. National regulators fret that they will be embarrassed by what it finds. This has prompted some to push back hard to limit the scope of the ECB’s inquiries.

Surprisingly, this resistance is not coming from countries on Europe’s periphery such as Spain (see article), which have much to gain from the imprimatur of ECB supervision. Rather it is coming from core countries such as France and, to a lesser extent, Germany, where seemingly well-capitalised banks may come out of the asset review looking threadbare.

One issue is the “risk weighting” of assets, a process by which banks adjust the size of their capital buffer to account for the riskiness of their lending. Studies by both the Basel Committee, a club of central bankers and supervisors, and the EBA have found wide and unjustifiable variations in the way banks risk-weight their assets, even when asked to do so for identical hypothetical portfolios. The consequences of such variations can be significant. If the euro area’s biggest banks were forced to abandon their internal risk-weighting models and instead apply cruder standardised models, many would see their core-capital ratios decline by several percentage points (see chart). The ECB is likely to push for greater consistency in risk weighting, which could force banks in France, Germany and elsewhere to raise capital.

Informed observers also expect the ECB to find evidence of “regulatory forbearance” in these markets, whereby supervisors have allowed banks to fudge the level of non-performing loans on their books, restructuring loans and easing repayment terms instead of taking write-downs. Adjusting for this could also open up capital holes. A process devised by Germany and France to shore up confidence in weak banks on Europe’s periphery may end up hitting a quite unexpected target.

About bambooinnovator
Kee Koon Boon (“KB”) is the co-founder and director of HERO Investment Management which provides specialized fund management and investment advisory services to the ARCHEA Asia HERO Innovators Fund (www.heroinnovator.com), the only Asian SMID-cap tech-focused fund in the industry. KB is an internationally featured investor rooted in the principles of value investing for over a decade as a fund manager and analyst in the Asian capital markets who started his career at a boutique hedge fund in Singapore where he was with the firm since 2002 and was also part of the core investment committee in significantly outperforming the index in the 10-year-plus-old flagship Asian fund. He was also the portfolio manager for Asia-Pacific equities at Korea’s largest mutual fund company. Prior to setting up the H.E.R.O. Innovators Fund, KB was the Chief Investment Officer & CEO of a Singapore Registered Fund Management Company (RFMC) where he is responsible for listed Asian equity investments. KB had taught accounting at the Singapore Management University (SMU) as a faculty member and also pioneered the 15-week course on Accounting Fraud in Asia as an official module at SMU. KB remains grateful and honored to be invited by Singapore’s financial regulator Monetary Authority of Singapore (MAS) to present to their top management team about implementing a world’s first fact-based forward-looking fraud detection framework to bring about benefits for the capital markets in Singapore and for the public and investment community. KB also served the community in sharing his insights in writing articles about value investing and corporate governance in the media that include Business Times, Straits Times, Jakarta Post, Manual of Ideas, Investopedia, TedXWallStreet. He had also presented in top investment, banking and finance conferences in America, Italy, Sydney, Cape Town, HK, China. He has trained CEOs, entrepreneurs, CFOs, management executives in business strategy & business model innovation in Singapore, HK and China.

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