Backstop before Asset Quality Review and Stress Tests in Europe

Europe is moving, however slowly toward a banking union.  The ECB has accepted a new demand--that it acts as the single regulator.  As makes sense, it is insisting before taking on this responsibility, it has a better sense of the bank assets and ability to withstand adverse developments. 

If it is judged that the banks need to raise capital, it also makes sense to ensure that there are facilities in place that will allow for this without triggering a new financial crisis.  

Banks would first try to raise the capital in the markets.  However, this option may not be really available for weaker banks.  There have been some agreements regarding the conditions under which the bank's creditors will have to bear responsibility (so-called bail-in clauses), but still seems incomplete.  

There are also supposed to be national recapitalization funds, but it is not clear whether these have been adequately financed.  What is even more to the point, many countries, including core countries like France and Germany, banking assets are some multiple of GDP.  There is the European Stabilization Mechanism, which has provided a backstop for Spanish banks, but it may be too conditional to be of help in an emergency. 

The EC has proposed a single resolution mechanism and claimed for itself the power to disburse funds.  This does not set well with several creditor nations, especially Germany.   Germany is reluctant to endorse the establishment of yet another fund and is opposed to what it sees as a power grab, preferring national governments retain the final approval.  

One of the under-appreciated aspects of a banking union is the uniformity of definitions and measures of assets.  There appears to be great variance within the euro area.  There is a suspicion too that national regulators may have granted regulatory forbearance and allowed liberal definitions of non-performing assets.  

The issue is also compounded by regulatory changes.  For example, Spanish banks have an estimated 50 bln euros in deferred tax credits.  These account for a little more than a third of the Tier 1 capital of Spain's banking system.  Under Basel III, deferred tax credits do not count as Tier 1 capital.  

The ECB is expected to set out the broad terms of the asset quality review later this month.  It will be conducted prior to the ECB's stress tests.  It is a preliminary examination to ensure that the new supervisor understands bank's balance sheets.  This will be followed by a more in-depth effort to make sure there is a uniform definition that is equally applied through the region.   After that comes the stress test.    

There is also the question of what to do about banks from countries that are not part of the EMU, but part of the EU, such as Sweden and the UK, for example.  There has been a proposal to earmark 50 bln euros from the ESM for non-EMU banks.  However, there is some debate whether this is permissible under existing rules or whether a treaty change is required.

The other wrinkle is that fact that negotiations to form a new German government look to be protracted.  It is not clear at this juncture, whether a new government will be in place by the end of the month.  It will most assuredly not be in place for next week's euro area finance ministers' meeting.  It is doubtful that it will be in place for the Oct 24 heads of state summit.