The year ahead will be one of major change for the European financial system. Decisions will be taken that will shape Europe’s banking system for years to come; for example, on whether to accept more or less cross-border bank consolidation. The European Banking Union will assume its definitive shape, while the ECB will become the single supervisor of Eurozone banks (ECB 2013). At present, investors have significant doubts about the quality of banks’ assets and the potential losses still hidden in their balance sheets. Market-based valuations of banks in Europe suggest that investors’ confidence remains low.
Figure 1 Price/book ratio (%)
Note: The data are computed as the un-weighted average of the largest five banks in each respective country.
Source: SNL Financials and Bruegel computations.
The implementation of single supervision could greatly reduce these concerns. The far-reaching preliminary assessment of banks’ balance sheets that will be conducted during 2014 can make balance sheet information more transparent, comparable and credible. For this to happen, some major uncertainties need to be addressed.
First, the central elements of the ECB’s balance sheet assessment exercise need to be clearly communicated. The ECB has already outlined the broad structure and some important technical elements (ECB 2013). The assessment will involve all banks to be directly supervised by the ECB – about 130 banks in 18 Eurozone countries – accounting for approximately 85% of total Eurozone bank assets. The comprehensive assessment will be undertaken by the ECB based on the transitional arrangements laid out in Article 33.4 of the SSM regulation. National authorities and the credit institutions concerned will supply the necessary information as requested. According to the ECB, the assessment has three elements:
- A supervisory risk assessment addressing key risks in the banks’ balance sheets, including liquidity, leverage, and funding.
- An asset quality review examining the asset side of banks’ balance sheets as of 31 December 2013. All asset classes, including non-performing loans, restructured loans and sovereign exposures, will be covered.
- A stress test building on and complementing the asset quality review by providing a forward-looking view of banks’ shock-absorption capacity under stress.
The ECB will set capital thresholds as a benchmark for the outcomes of the exercise amounting to 8% Common Equity Tier 1 (CET 1). The threshold is decomposed to 4.5%, which is the ratio that will be legally mandatory as of 1 January 2014 according to Capital Requirement Directive1 and the Capital Requirement Regulation,2 a capital conservation buffer of 2.5%, and an add-on of 1% to take into account the systemic relevance of banks. There is still some uncertainty regarding the definition of capital because of the various transition periods in the CRD IV and the timing of the ECB exercise (for details, see Merler and Wolff 2013).
There are also a number of crucial issues that remain to be settled. These include, in particular, the treatment of sovereign debt, the magnitude of the stress test and the treatment of systemic risk. The choices to be made on these issues will potentially affect the results significantly. In fact, the lack of information about the balance sheets of banks, together with the uncertainty about these central parameters of the exercise, can probably explain the significant variance in market estimates of the recapitalisation needs that might be identified by the stress tests for the Eurozone banking system. The estimates that we could collect in Table 1 vary between €50 billion and €650 billion, depending on the different way systemic risk is accounted for (Merler and Wolff 2013).