• Industry: Financial Services
  • Type: Regulatory update
  • Date: 4/2/2014

Update on Asset Quality Review 

On 3 February 2014, Vítor Constâncio, Vice-President of the European Central Bank (ECB) and Danièle Nouy, Chair of the ECB Supervisory Board, gave a press briefing on the Asset Quality Review (AQR). During the briefing, clarity was given around Level 3 assets; the definition of Non-Performing Exposures; Internal-Ratings Based (IRB) models; capital backstops; and ultimately the unprecedented scale of the Comprehensive Assessment process.

Disclosure was carefully managed; the AQR methodology will not be published until later this quarter. The ECB showed its hand on the points of emphasis for AQR however. Central among these is a focus on ‘Level 3’ assets, an IFRS classification of assets whose fair-value is not observable in the market, but is marked to a financial model.

Level 3 assets represent a small proportion of total assets across Europe (below 5% for the vast majority of banks subject to the Comprehensive Assessment), but are potentially the darkest corners of banks’ balance sheets. The ECB is clearly determined to shine a light on them. A detailed review of the Trading Book, focused in particular on Level 3, will be mandatory for all banks whose Trading book is material. This will be performed alongside the credit file-review traditionally viewed as the core emphasis of AQR.

The ECB clarified the definition of Non-Performing Exposures, noteworthy for its simplicity: any exposure over 90 days past due is classified as non-performing. We expect this to lay bare the divergent practices of European banks with respect to forbearance. Other things being equal, we anticipate increased NPE rates being reported in most euro-zone countries (noting that certain Greek banks are already at 35%).

The ECB admitted that another area of divergent practices across European Banks, namely the divergent risk weights used in internal ‘IRB’ capital models, is ‘too big to fix’ during the 1-year Comprehensive Assessment process.

Reviewing Internal-Ratings Based (IRB) models will be a core focus for the ECB once it takes on supervisory responsibilities in November 2014. In the interim AQR will constitute a tactical fix by requiring banks to increase provisions, and thereby capital, directly. Capital shortfalls found in the AQR sample will be extrapolated across the relevant portfolio.

The ECB emphasised that backstops are in place for banks with insufficient capital, notably the European Stability Mechanism (ESM). Mr Constâncio also stressed the importance of AQR in establishing the ECB’s reputation, hence the need for an impartial review, underpinned by independent valuations of real-estate and other assets.

Capital gaps uncovered will be disclosed after the ECB/EBA stress test, for which we now know the capital hurdle rates (8% CET1 under base scenario and 5.5% CET1 under adverse), but not the scenario assumptions, to be defined country-by-country to account for differing ‘macro’ backdrops. Default and loss parameters for sovereign exposures will be adjusted by the ECB in ‘stressed’ scenarios, potentially resulting in decreased forecast coupon and redemption payments on sovereign debt and consequently a haircut to their book value.

Several times Mr Constâncio reminded us of the unprecedented scale of the Comprehensive Assessment process. If completed in line with the ECB’s timeline and objectives, it will provide an unprecedented benchmarking (and potentially re-capitalisation) of European banks. There are many stakeholders in the review process however – establishing the ECB’s reputation without damaging those of incumbent national regulators may prove a delicate balancing act.

For further information, please contact Stephen Smith or Marcus Evans.


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