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.