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While the sense of crisis in the European financial system has eased in recent months, the true state of the Continent’s banking system remains a mystery. In most cases there is little information in the public domain about bank balance sheets, with even regulators having little understanding of the risks banks are taking.
But as consensus builds that banking union is the only viable option for getting closure following Europe’s bruising sovereign debt crisis, politicians have recognised the need to take a close look under the hoods of Europe’s banks.
“Any financial risk mutualisation must be preceded by a credible removal of legacy risks resulting from past national banking policy choices,” said Nicolas Veron, senior fellow at think-tank Bruegel and visiting fellow at Peterson Institute for International Economics in Washington.
European authorities have a three-pronged strategy for making this assessment: a supervisory risk assessment analysing balance sheet risks such as liquidity, leverage and funding; an Asset Quality Review; and a stress test.
For now the AQR and the stress test remain black boxes, with no details concerning the methodology yet to be finalised. Predicting which institutions will be flagged up with problems is therefore impossible. What is known is that banks failing the AQR process will require restructuring, although even here, important decisions about that process have yet to be taken.
In terms of methodology, “there are initial exemptions for smaller banks with a balance sheet total under €30bn, a category that includes most German saving banks and co-operative banks, but the ECB can later choose to supervise them directly as well”, said Veron.
The omission of large parts of the German banking system from the assessment is not ideal, meaning any picture that emerges will be incomplete. But it is hard to criticise the authorities for this given the size of the ECB’s task; regulators lack the resources to scrutinise every bank in Germany, let alone Europe. And observers generally seem comfortable with the thresholds for inclusion that have been set.
It is also possible that the ECB will expand its scope over time, bringing more smaller German banks under its influence.
“This is likely to be especially sensitive in Germany, where savings banks and co-operative banks are subject to highly specific oversight regimes,” said Veron. “But leaving these banks permanently outside of the ECB’s direct authority may also give rise to perverse incentives and regulatory arbitrage, which in turn could generate potential instability over the longer term.”
The question is, how valuable will this partial picture of the German – and European – banking sector be?
“The AQR will capture a significant proportion of the troubled banking system,” said Veron. “German savings banks, which are not included in the AQR, may have problems, but they are not now a source of systemic risk for Europe. When they have encountered problems they have always been quietly rescued by their neighbours and local government. In the long term there is a risk of regulatory arbitrage but there is no great short-term risk.”
Without more clarity about the process it is very difficult to predict the outcome of the AQR and stress tests. But the process is likely to be rigorous, with a number of failures expected, said Christian Dubs, a financial analyst at Julius Baer.
These are unlikely to come from those countries that have already received European assistance: banks in those countries have already provided greater disclosures than most, meaning there is less potential for surprises. However, these represent only one-quarter of the banks to be subjected to the AQR, with only about 20% of total assets, said Veron.
“Issues are more likely to arise for banks with risky portfolios where no action has been taken on a national level,” said Dubs.
“This will affect certain German banks with large exposures to shipping and real estate, Austrian banks with high exposure to Eastern Europe, and mid-size Italian and French banks, which could face some headwinds from the macroeconomic situation in their countries.”
There is a sense that the German banking system as a whole is relatively healthy. German banks have the obvious advantage of operating in Germany, a relatively strong economy compared with others in Europe. Loans to local businesses in Germany will therefore generally be safer than similar loans in Spain, for example.
However, as confidence grows that Europe’s politicians will stand behind the European project whatever happens, market confidence is returning and the spread between German banks and others in the market is declining. The market clearly believes the assurances.
“Rating agencies may soon change their methodologies to allow banks to be rated higher than their sovereign – this is not yet the case,” said Veron.
“Our assessment indicates that German banks have strong liquidity, average leverage and select funding weaknesses, suggested by reliance on non-deposit sources,” said Barclays Credit Research. “The comprehensive assessment should prove to be beneficial for the German banking system, highlighting that banks are broadly resilient.”
However, with the exception of Deutsche Bank, the German banks included in the AQR are not typically the large deposit-taking institutions. It will therefore be interesting to see what conclusions the ECB reaches about their liquidity profiles.
The AQR is likely to find “German banks to be well positioned, with conservative non-performing loan classifications, manageable amounts of bad loans and adequate provisions,” said Barclays, although “select banks such as HSH and Nord/LB have below-average provisions and in some cases elevated non-performing loan ratios, largely related to shipping portfolios”. (See p12)
Barclays assessed six German banks. The two largest commercial banks, Deutsche Bank and Commerzbank, were joined by Bayerische Landesbank (BayernLB), Norddeutsche Landesbank-Girozentrale (Nord/LB), Landesbank Hessen-Thueringen Girozentrale (Helaba), and HSH Nordbank AG, among the largest banks with subordinated bonds in the credit market.
“The shock absorption capacity of German banks is moderate, with limited flexibility at HSH and Nord/LB, although HSH is likely to benefit from the existence of a state guarantee on select loans,” said BCR.
Barclays predicted that attention would centre on “the most risky or non-transparent assets, which will be subject to strict minimum coverage criteria”.
Shipping and commercial real estate account for 9% and 3% of lending, respectively, of the German banks in the study, compared with corporate and retail lending, which account for nearly half of aggregate credit exposure.
“Shipping exposure amounts to nearly a fifth of total exposure at Nord/LB and HSH, while it is just 3% at Commerzbank and minimal at Deutsche Bank, BayernLB, and Helaba,” said BCR. “Nord/LB and Helaba also have the highest proportional exposure to CRE, while at c.€50bn BayernLB’s CRE book is the largest in absolute terms.”
“Among core European banks, German banks have the second-highest exposure to peripheral countries after the French banks,” said Barclays. “The total sector exposure to Greece, Italy, Portugal, Cyprus, Spain, and Ireland currently stands at €234bn, or 5% of total assets, although it has been reduced by nearly €200bn since Q4 2009.”
No pain no gain
A lot rests on the credibility of the AQR process. If credible, it should restore trust and confidence in the banking system, allowing all past mistakes to be identified and then addressed.
“Following this, banks would be under much less suspicion of keeping skeletons in the closet than has ever been the case since 2007, both from the investor community and from each other,” said Veron.
There is a general feeling that the process will be more revealing, and more credible, than past bank stress tests have proved to be.
“The context of this review is fundamentally different from the stress tests of 2009 and 2010,” said Veron. Earlier attempts were widely seen as policy failures, giving a clean bill of health to banks that collapsed shortly afterwards. The key difference this time, he said, is the AQR that supplements the stress tests.
The regulator driving the process is also more credible. “In contrast to the CEBS and EBA, the ECB has direct relationships with the reviewed banks, direct access to all supervisory information, wide legal authority to request information from both the banks and national supervisory authorities and the ultimate ability to revoke a bank’s licence after the handover on November 4 2014,” said Veron.
However, credibility is not a given. “There is no corporate accounting department at the ECB, which is something you would expect to be necessary for it to complete this assessment,” said Veron. “The technical difficulties presented by the AQR and stress tests should not be underestimated.”
“Current levels of transparency vary enormously across countries and bank models,” added Veron. “Among the 124 banks in the AQR sample, less than half, representing about 60% of total assets, are publicly listed or part of listed groups, and thus subject to the disciplines of listed-company disclosure.”
Although they may have healthy balance sheets, for now unlisted banks in non-programme countries are most likely to contain surprises. These banks account for 43% of the sample, with almost a third of the total assets. In Germany such banks have around €3.2trn of assets, and relatively little is known about their balance sheets.
“Accounting in Germany has its own traditions based on the strength of the relationship between banks and their corporate clients,” said Veron.
“The sense that the wider public is entitled to corporate governance and accounting information is far less developed than in the US, for example. This makes the AQR more challenging in Germany than in some countries and also means the chance of getting new information at the end of it is much higher.”
For Europe to get real benefits from the process, authorities must therefore be brave enough to confront whatever unpleasantness lurks on bank balance sheets, and competent enough to locate it.
“Accounting and valuation are very drab subjects but they are crucial to the question of how robust this process is going to be,” said Veron.
If it is successful, however, Germany – and the Continent as a whole – can move forward towards full banking union and a revitalised banking sector, putting the problems of recent years behind it once and for all.