Cracks in the Stress Tests of European Banks
NOV. 1, 2014
By GRETCHEN MORGENSON
The sigh of relief was almost audible last week when the European Central Bank published its long-awaited safety and soundness report on 130 banks in 19 countries in the region. Many investors seemed comforted that just 13 banks had failed the comprehensive exam.
But there is much more to the report than a pass/fail grade for Europe’s banks. And some of the findings should trouble any investor interested in the accuracy and comparability of European banks’ financial statements.
A crucial aspect of the examination was an analysis of how each bank valued its assets, such as loans and interest-rate swaps and other derivatives holdings.
The derivatives holdings on these institutions’ books total hundreds of billions of euros. So it’s critical that banks accurately assess the risks that arise in these holdings when a trading partner gets into financial trouble. (This assessment is called a credit value adjustment.)
The analysis was discomfiting. The European Central Bank concluded that fully half of the sampled banks had inadequate practices when it came to calculating and adjusting their holdings for credit risks associated with derivatives trading partners.
Here is another disturbing data point: More than one-quarter of the banks — 28 percent — were found to be less conservative in their classifications of nonperforming loans than the central bank’s definitions required. And roughly a quarter of the banks had substandard processes related to independent price assessments of assets.
The problems were not inconsequential, the report concluded. Improper valuations of bank assets required adjustments of 48 billion euros ($60.5 billion) at the institutions, and the capital shortfalls identified at 25 banks under an adverse economic scenario totaled €25 billion as of year-end 2013.
Twelve of the banks raised capital this year, reducing the shortfall figure.
Vincent T. Papa, director of financial reporting policy at the CFA Institute, a global association of standard-setters for investment professionals, said the report was a worthy first step. “But,” he said, “while the focus of the report is on what’s in these institutions’ financial statements, it also shows that what they disclose needs to have greater integrity.” He added: “A huge subset of the banks are not being as rigorous as they should be.”
The integrity of large banks’ financial statements could not be more important. Given the €22 trillion held in these banks and the vast interconnections among financial institutions, any missteps could disrupt world economies. (Mr. Papa said United States banks were better at setting money aside more quickly for loan losses and repairing their balance sheets than banks in many other regions.)
The European Central Bank said its analysis was intended to strengthen banks’ balance sheets, improve transparency in reporting and persuade investors that these institutions are sound.
But the trillion-euro question remains for the future: What will financial supervisors do to ensure that banks report accurately on their assets and risk exposures?
For the immediate future, banks with capital shortfalls have to submit plans detailing how those gaps will be covered. Shortfalls identified in an analysis of an “adverse” economic projection must be covered by the end of next July.
But further regulatory policing will be necessary to assure investors that banks’ assets are being properly valued year in and year out.
“If this is a one-off exercise,” Mr. Papa said, “it is not sufficient to build investor confidence in the transparency of bank reporting.”
The publication last week of the central bank’s test results came ahead of its scheduled takeover of supervisory tasks this month, as part of the single regulator in the region. And in its report, the central bank said the results would be taken into account as it took up the supervisory role. Given the flaws in asset valuation uncovered by the study, the regulator has much work to do. Some banks, for example, were unable to assign proper values to the most basic assets.
Accounting rules have three valuation buckets into which companies can put their assets. They are known as Levels 1, 2 and 3.
Level 1 assets are typically the easiest to value, because they often trade on public exchanges or have otherwise observable prices. Assets assigned to Levels 2 and 3 do not trade regularly and are tougher to value. Assessing these holdings involves making estimates.
Even though Level 1 assets are typically liquid and transparent, the European Central Bank disagreed with how the banks classified 13.5 percent of them in the study. This is a striking failure.
The regulator also said that when reclassifying an asset’s fair value, the banks erred on 10 percent of assets. One-third of the banks sampled did not have a clear policy or process for classifying assets traded in active markets, the report concluded.
A report published in August by the CFA Institute presaged some of the central bank’s findings.
That analysis examined large and complex banks in 16 countries for the 10 years ended in 2013. That included years before and after the financial crisis.
Over that period, Mr. Papa and his colleagues found wide variations in the way banks valued their assets. Yet these institutions’ financial statements contained few details about the factors contributing to the valuation gaps.
Most striking was the difference in how long it took for some institutions to recognize that a loan had become impaired and that setting money aside for a loss was necessary. That banks in different countries took such different approaches to write-offs raises questions about the accuracy of these institutions’ financial statements, Mr. Papa said.
“There was an indication within the E.C.B. report that there would be a follow-up on some of the areas of weakness,” Mr. Papa said. “Clearly, some ground needs to be covered. Investors need a more active role by securities regulators and more robust disclosures.”
In other words, the stress-test findings last week shouldn’t be the end of a process. They should be the beginning.
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