Draghi Builds Stress-Test Credibility in ECB Bank Review

The European Central Bank is showing that it can repair the reputation of stress tests. ECB President Mario Draghi has said he won’t hesitate to fail lenders if needed, signaling a determination to prove the central bank can spot weaknesses before it becomes the euro area’s single bank supervisor in November. European Union-wide stress tests in 2010 and 2011 were criticized for failing to reveal deficiencies even when balance sheets were pitted against a range of hypothetical, negative events.

“Yes, it will be more credible,” said Tomas Holinka, an economist at Moody’s Analytics in Prague. “Although it will be extremely difficult for the ECB to say the truth, the risk of a lack of credibility will prevail and the ECB will stress that some banks need to raise additional capital.”

Restoring Confidence

In the Bloomberg survey of 34 economists, conducted from Dec. 6 to Dec. 11, 32 respondents said the stress tests will be more believable. The results also showed economists expect the ECB to introduce liquidity measures linked to bank loans, while they were split on whether there will be new action on monetary policy in the first quarter of 2014.

Draghi’s task is to preside over a three-stage review, known as the Comprehensive Assessment, that’s tough enough to give investors confidence that the region’s banks can withstand more economic turmoil if it comes. At the same time, if he pushes so hard that a slew of lenders flunk the exam, faith in the banking system may be eroded further.

Draghi said in October that if “banks have to fail, they have to fail.” He said on Dec. 5 that the “ultimate test of credibility” of the review is that institutions regain the confidence to resume lending to each other.

The ECB president may face questions on the central bank’s plans for the assessment when he addresses the European Parliament today in Strasbourg, France. The parliament yesterday appointed Daniele Nouy as chief supervisor of the Single Supervisory Mechanism.

Tough Tests

In an interview with the Financial Times published today, ECB Executive Board member Peter Praet said that if the Comprehensive Assessment put pressure on banks in a way that forced them to cut lending, the central bank could act by providing more liquidity.

Targeting sovereign bonds in the stress test could also mean banks would be less likely to load up on government debt using ECB funds, as had been the case during a round of three-year loans at the end of 2011 and beginning of 2012, Praet said in the interview.

“This is because banks will be wary of the constraints placed on sovereign debt by the stress tests to which they are subject at the same time,” he said.

In 2011, eight banks failed the EBA tests with a combined shortfall of 2.5 billion euros ($3.5 billion). Dexia SA, the French-Belgian lender, received a clean bill of health and then failed amid a bank run three months later.

Banks are still waiting for the ECB to say how severe next year’s exam will be. Executive Board member Yves Mersch hinted this month at some elements of ECB thinking on the design of the two scenarios under which assets will be tested, while saying that full details will only be released at the end of January.

Scenarios

Lenders now know that the stress test will have a basis scenario and an adverse-conditions scenario that covers a three-year horizon. Details on how hard government bonds will be stressed and how much capital will be required of banks after the imagined negative scenario have yet to be fleshed out.

The ECB “will continue to weigh the benefits and drawbacks of a tough test,” said Elwin De Groot, an economist at Rabobank in Utrecht, Netherlands. “The ECB has a strong interest in making it more credible.”

In 2011, the EBA’s adverse scenarios, created with the ECB, included a 0.5 percent economic contraction in the euro area, a 15 percent drop in European equity markets and losses of 10 percent on real-estate assets. The tests didn’t assess the effect of a sovereign default on government debt held to maturity.

The need to have the right kind of result this time round may influence the design, said Duncan De Vries, an economist at Nibc Bank NV in The Hague.

“As these tests are intended to rebuild confidence in banks, the result will unlikely be that a significant number of banks will fail the tests or have to raise large amounts of new capital,” he said.

Bank Deleveraging

Investors may gain an early insight into the health of balance sheets next week. The EBA plans to publish information on Dec. 16 showing banks’ holdings of sovereign debt and securitized assets, and the methodology for calculating capital buffers.

Until the ECB completes its assessment, bank lending will inevitably be affected by the process, ECB Vice President Vitor Constancio said yesterday. Bank lending in the 17-nation euro area has contracted for 18 straight months.

“Because banks are preparing and they don’t want to be caught in anything, so they deleverage and they sell assets and all of that to have a better balance-sheet situation,” Constancio said in Frankfurt. “This may also induce a certain effect that restricts credit, but it is unavoidable, it’s for a good cause later on. We have to accept this.”

Lending Boost

The Bloomberg survey showed that most economists see the ECB taking steps to spur lending to companies and households, with 25 of the 34 respondents predicting a conditional liquidity operation. The Bank of England started a similar program, Funding for Lending, last year.

Thirty-eight percent of the economists said the likelihood of new monetary policy action in the three months through March has declined. The ECB cut its benchmark rate to a record low of 0.25 percent on Nov. 7. Twelve percent said the probability of action has increased and half said there has been no change.

Draghi told reporters after the Dec. 5 rate-setting meeting that “decisive” steps to establish a European banking union will restore confidence in the banking system, while acknowledging that the ECB’s assessment “is not an insignificant amount of work.”

“The ECB has every incentive to demonstrate that its credibility is untainted by its role of supervising large European banks, but obviously there are going to be shortcomings as well,” said Christopher Matthies, an economist at Sparkasse Suedholstein in Neumuenster, Germany. “We do think that there is a learning curve by those who design these tests.”

(Source: Bloomberg)