The ECB’s bank review: Kill the Zombies and heal the wounded

The European Central Bank’s comprehensive assessment of euro area banks has had an encouraging start. But complacency could still lead to another failed attempt to fix Europe’s banks, with severe consequences.

The ECB’s bank review looks like it will be more credible than the discredited EU-wide stress tests in 2010 and 2011. The ECB has its own reputation at stake, and has strong incentives to ensure that legacy problems are addressed before taking over from captured national authorities as the banks’ direct supervisor.

Unlike earlier exercises, the assessment of banks’ soundness starts with an Asset Quality Review (AQR), which is an examination of the asset side of bank balance sheets as of the end of 2013. The exercise involves 128 banks and covers the vast majority of the euro area’s banking assets. Asset valuation adjustments following the AQR will feed into forward-looking stress tests factoring in adverse economic assumptions, on the basis of which the ECB will assess the banks’ capital shortfalls. Previously, banks and supervisors in different countries adopted different and often lax approaches to the valuation of assets, collateral and guarantees and to the classification of impaired loans. By using an army of auditors to assess non-performing exposures, collateral, and provisions, the AQR should enable the ECB to assemble and disseminate consistent information across banks and countries. In an encouraging sign, this exercise appears to have already spurred many banks to increase loan-loss provisions and capital.

But the most critical part of the exercise still lies ahead, and could be harder than many investors and policymakers expect. The technical and logistical challenges alone are daunting, especially because the ECB is still building its staff and skills.

In addition, national supervisors will still play a critical role. They can use their position on the new Supervisory Board within the ECB to promote the narrow interests of banks and authorities in their countries. For example, the published benign assumptions for the adverse scenario in the stress tests — such as only a mild decline in property prices in Ireland, or no allowance for deflation in countries such as Spain — were likely promoted by national authorities. Weak stress assumptions make it more difficult for the ECB reestablish trust that banks are sound.

Another danger is that the results may not be disseminated quickly enough or in a transparent manner. The AQR is to be completed at the end of July, followed by the stress test, but the ECB does not intend any disclosures until late October, and may delay necessary supervisory actions beyond this date. But securities laws may require earlier disclosure of any discrepancy between previous and new estimates of capital, for example.

In the absence of a common euro area backstop to protect market confidence, there is a further danger of regulatory forbearance in the form of understated capital needs. Many also fear that the ECB might single out problems in banks from smaller and less powerful countries in an attempt to make the exercise look credible, while papering over cracks in more powerful countries. Even in small countries, the ECB may hesitate to declare a bank insolvent if the national government appears unable to deal with it. Capital requirements may also be understated for technical reasons, because of the primary reliance on complex risk-weighted ratios that can be manipulated and because of the ECB’s own lack of deep accounting and valuation experience.

Closing unviable banks and recapitalizing and restructuring viable ones are inherently painful and politically charged steps. Structures to manage failed banks and assets remain inadequate in Europe. In addition, domestic bank governance structures (e.g., the role of foundations in Italy, regional cooperatives that control Crédit Agricole in France, or public shareholders in Germany) could impede the ability to raise new capital. Before the EU’s Bank Recovery and Resolution Directive takes full effect in 2016, the policy stance toward forcing losses on (or bailing in) unsecured bank creditors if there is a capital shortfall remains unclear.

Overcoming these handicaps is feasible but difficult. To maximize prospects for success, the ECB must first be prepared to mercilessly identify the weaker banks, including “zombie” banks that pretend to be sound, abetted by complicit national authorities. The AQR and stress tests should separate banks into three groups: those that are sound without additional corrective measures; those that can be made viable with corrective measures; and those that are not viable and should be closed in an orderly manner, which could include a merger with other strong banks. Kill the zombie banks, and heal the ones that are only wounded. Danièle Nouy, the euro area’s new chief supervisor, has acknowledged that some banks must disappear. Delivering on this will be critical.

This policy does not imply a target big number for the aggregate capital gap for the euro area. The critical success factors will be rigor and evenhandedness in identifying capital shortfalls in core countries as well as the periphery, and not shying away from declaring banks to be insolvent. Encouragingly, independent estimates of the aggregate capital shortfall such as those by Viral Acharya and Sascha Steffen suggest that even if public backstops are needed, their magnitude will not likely damage sovereign debt sustainability.

Transparency is essential. As Karl Whelan has pointed out, the standards must be higher than the cursory disclosure of AQR results by Irish banks in December 2013. Investors will want to know how supervisors deal with losses denied by banks claiming differences over asset classification or collateral valuation. Plans should be made to reduce the danger of chaotic dissemination of AQR results between July and October, emphasizing disclosure to provide uniformity and reduce unwarranted market turbulence. Although the stress test’s capital thresholds are defined in terms of risk-weighted assets, the disclosures should also include simple leverage ratios to provide a more complete judgment of whether banks are adequately capitalized.

Finally, member states need to adopt a rigorous approach to rectifying capital shortfalls while minimizing cost to taxpayers. Orderly resolution of insolvent banks should include writing down not only shareholders’ equity but also hybrid instruments and subordinated debt. All member states that lack laws to do so should urgently enact them. Unsecured senior bonds should be “bailed in” to reduce the cost of resolving zombie banks. The corresponding requirements of the Bank Recovery and Resolution Directive do not come into full effect until 2016 and it is too late to amend EU legislation in time for the AQR results. Under these circumstances, a political agreement to adopt a common approach that imposes losses on unsecured senior creditors of zombie banks would avoid damaging divergence from one member state to another.

Shareholders of wounded but viable banks needing increased capital buffers should not be rewarded until satisfactory capital levels are attained. In addition, banks unable to raise sufficient private capital should come under state aid rules, making conversion of junior debt to equity a condition for public assistance. In sum, restoring confidence and clarity and minimizing cost to taxpayers should trump protections for subordinated and senior bank debt.

Closing dysfunctional zombie banks and restoring wounded ones to health will not be enough to pull the euro area out of its economic and political funk. But the hard work of recognizing bad loans and recapitalizing and restructuring banks will reduce the current drag on growth from banks that squeeze credit even from promising firms, and will contribute to economic expansion and employment. Europe’s policymakers need nerve and clear-sightedness for this opportunity not to be wasted.