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ECB Evaluations Raise Reporting Questions

The European Central Bank is in a quandary. It's doing a three-phase assessment of 128 large and “systemically important” eurozone banks, over which it will assume authority come November, and as part of that assessment wants those banks to report in a standardized fashion on the quality of the debt they hold.

At issue is how strict reporting rules should be, since a strict rule will provide a more accurate picture of banks’ financial condition, while more relaxed reporting standards could allow some troubled banks to slip under the radar, mar the credibility of the assessment and perhaps even cause panic when their true condition comes to light.

“The exercise has three main goals: transparency—to enhance the quality of information available on the condition of banks; repair—to identify and implement necessary corrective actions, if and where needed; and confidence building—to assure all stakeholders that banks are fundamentally sound and trustworthy,” the ECB said.

So the solution seems easy: make everyone report according to the same stringent rules. That would lay open any potential problems and also give the world confidence that the assessment is the genuine article instead of a sham exercise.

But that approach has two problems. First, not all those banks are capable of doing as the ECB wishes, since different countries classify debt in different ways. Second, and perhaps more important, is the possibility that banks carrying a load of bad debt could be shooting themselves in the foot if they officially acknowledge the extent to which they're on the hook.

In an internal document, the ECB acknowledged that strict standards are necessary for credibility. “A more ambitious definition would be consistent with the need to convey to external observers that the AQR [Asset Quality Review, the second stage of the assessment] is a thorough exercise.”

But at the same time, the ECB expressed concern that more lax standards would result in a failed assessment in more ways than one, since banks may not be able to comply even if they wish to. The ways bad debt is classified throughout Europe, said the document, indicate “material differences that, if not considered, would severely affect the consistency and credibility of the exercise.” Of course that doesn't make the ECB happy, since it's going to be responsible for riding herd on these banks before the end of the year and would like to have a fairly accurate assessment of what it's letting itself in for.

That's where the second problem rears its ugly head. Banks laden with bad debt, a.k.a. "zombie banks," could invite panic if the true extend of their financial troubles became known. Of prime interest are the banks in Greece, Ireland, Italy, Portugal and Spain. According to the ECB's own figures in its Financial Stability Review, released in November, the banks in just three of those countries are in for losses of approximately $250 billion. The ECB has to figure out which of those banks hover on the brink of disaster, and which among them should be allowed to fail rather than thrown a lifeline.

If the ECB guesses wrongly, it could be very expensive for all concerned. Still, opportunities lurk amid the host of unknowns—but investors must be wary.

The London-based European Banking Authority (EBA), which will work with the ECB on the stress tests that are the third part of the assessment, issued a set of definitions for nonperforming loans in October. This month it was announced that a simplified version of those definitions is being used instead, despite the preference of some at the ECB for the more comprehensive version. Banks were sent questionnaires on their trading books and risk models on January 13, and have until the end of the month to provide the data. Other data requests were issued before Christmas.

Despite the change in definitions, national rules could still make it impossible for some countries’ banks to comply. And the ECB has said it will use the EBA’s simplified definitions as a baseline, while trying to get more details on nonperforming loans.

The coming stress tests could also compel banks to offload some of their high levels of nonperforming debt—perhaps as much as $82 billion—which in turn could impact markets. While some investors will want to stay away from banks with heavy loads of bad debt, other investors could be tempted to explore opportunities presented by such levels. When the three-stage assessment was announced in October, Ernst & Young said in its annual investor report on nonperforming loans that such debt was a draw for investors in the sector.

In the report, Howard Roth and Christopher Seyarth, partners at EY, said, “European banks have increasingly begun to reduce their exposure to NPLs via portfolio sales. Consequently, global NPL investors are turning their attention to Europe, and for good reason. An estimated 1 trillion euros of NPLs are sitting on the balance sheets of the region's banks, far surpassing the magnitude of distress in the U.S.” They added that the most attractive countries for such investors were Germany, Ireland, Spain and the U.K.

Another potential problem is too-harsh grading of troubled banks that could chase rather than draw investors, so the ECB must walk a fine line in its assessment.

Will failure to obtain more comprehensive data on nonperforming loans, or even revelations of massive debt levels, cause a delay in implementation of the ECB’s dominion over eurozone banks? Not likely, said John Blank, chief equity strategist for Zacks.

“The bad debt issue is endogenous,” said Blank. “It’s influenced by how the economy does. There used to be a lot of basket cases, but not now. There are fewer foreclosures [and other problems]; the economy is better.” Spain, Italy and Greece present the most problems, especially Greece with its 27% unemployment rate and depression-level economy. And the ECB’s evaluation depends “on how you want to classify the debt, who acquires it, where it goes, even if it’s done by now. It’s a colossal situation, and mostly likely will not get resolved [even] in the next year or two.”

But that’s not to say it will be a stumbling block for the ECB’s planned authority over eurozone banks. “Portugal’s out of the game, Ireland is now growing ... Greece and Spain will get attention and accounting,” Blank said. “It ends up being the same story we’ve [already] seen over and over.... Economies are improving in enough of the places and even Spain’s growth is ahead of Italy’s. [The authorities] will say, ‘You’re getting there, you’re turning around.’ They’ll shrug it off and move along.”

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