To inform the balance sheet repair that EU banks require to restore investor confidence and in preparation of its broader supervisory mandate of EU banks, effective 4 November 2014, the European Central Bank (ECB) has been conducting a comprehensive assessment of EU banks for the past 12 months. At the core of the assessment is an asset quality review (AQR) that will be founded upon 128 EU-based bank balance sheets as of 31 December 2013 (see ECB FAQ for details).
The AQR results are expected in October, and bank investors and other industry watchers keenly await the findings. As reported in a recent Wall Street Journal article, one of the anticipated outcomes of these results is the identification of banks that have failed the capital adequacy stress tests and thus need to take reparative measures (e.g., raising additional capital, deleveraging). A recent Bruegel blog post, “Who is Afraid of AQR,” observes that banks in different EU jurisdictions (e.g., Spain and Italy) have had significant impairments and provisions of loans (€135 billion) in 2013 most likely in anticipation of AQR.
Investors expect that the AQR will provide a better sense of the veracity of net asset values reported on EU bank balance sheets. As CFA Institute highlighted in our recently published bank research report, there was a significant likelihood of the assets on EU bank balance sheets being overstated due to the delayed write-downs (impairments) of loans. Our study also showed an incremental risk aversion towards EU banks, evidenced by incremental CDS (credit default swap) spreads during key stages of the financial crisis, signaling investor uncertainty on the overall risks and true value of banks.
AQR Focus Areas
AQR encompassed on- and off-balance sheet exposures with a sample selected covering 58% of risk-weighted assets worth €3.72 trillion; 65% coverage was on corporate portfolios and 29% on retail assets. Below are a few AQR focus areas of interest, excerpted from an ECB press release.
- Processes, policies, and accounting review: Key topics include whether a bank correctly applies the fair value hierarchy, accounting classifications (e.g., available for sale), provisioning approach, treatment of nonperforming exposures, and forbearance.
- Credit file review: Verify that credit exposures have been correctly classified (e.g., placed in the correct regulatory segment, nonperforming loan status, impairment status) and that, if a specific provision is required, it has been set at an appropriate level. The credit file reviews will cover all loans, advances, financial leases, and other off-balance sheet items, including specialised asset finance such as shipping and project finance.
- Collateral and real estate valuation: the majority of collateral will be revalued for selected debtors that do not have a third-party valuation less than one year old.
- Collective provision analysis: Smaller, homogeneous, impaired exposures are typically provisioned using a collective provisioning approach. The analysis will verify that provisioning levels are appropriate by ensuring that collective provisioning models are fully aligned with the letter and spirit of accounting rules.
- Level 3 fair value exposures review: For banks with material level 3 exposures, a thorough revaluation of the most important exposures will be carried out on a selective basis.
- Determine AQR-adjusted Common Equity Tier 1 Capital
With its coverage of the above areas, the AQR will address several deficiencies identified in existing bank reporting.
Will AQR Meet Investor Expectations?
It is not unusual to encounter commentary positioning the AQR as some sort of panacea that will cast light on all the dark alleys that investors struggle to navigate while ascertaining the value and risks associated with EU bank assets and liabilities. With this kind of expectations, there is always the risk that the results could end up being a damp squib, as was the case when the European Banking Authority (EBA) released the stress test results in 2010, and a few banks that passed needed to be rescued. In contrast to the previous EBA stress tests, there is a general expectation that the AQR results will be more credible in identifying capital shortfalls and should thereafter trigger the necessary balance sheet repair measures.
The earlier ECB press release communicates that there will be potential for restatement of 2013 annual reports in the event of identified accounting irregularities, though the ECB has indicated that this is expected to be rare, if at all. In the event that, say, the loan provisions are found to be understated or where a credit valuation adjustment has not been made for reported derivatives values, these will be adjusted on a one-off basis in the 2014 annual report.
That said, thus far, it is not clear whether and the extent to which there will be transparency around the entity-specific assumptions underpinning any AQR-related financial statement adjustments, and whether these adjustments, when they occur, will be clearly presented or disclosed in the 2014 financial statements. It is also not clear how adequately the AOR will cover all key risk exposures given that the selection of analysed assets is based on their risk weights. The risk-weighted methodology has proven to have shortcomings as far as not appropriately reflecting the risk of sovereign debt securities and also due to risk-weighted assets not being comparable across banks.
Hence summing up, it is worth emphasizing that it is premature at this stage to judge the outcomes of the forthcoming AQR results. If anything, it will be a point of great interest, as to the extent to which the AQR will actually contribute to greater transparency of banks and to the full restoration of investor confidence in the sector.
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Image credit: Valero Duval, 2014