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AQR and stress tests: this time, it's a real step forward

By Owen Sanderson
21 Oct 2014

European banks have been in limbo this month, waiting for their regulators' verdict to be handed down in the Comprehensive Assessment (the Asset Quality Review and stress tests). There are gaping holes in the assessment process but, even so, it is something quite new and potentially revolutionary.

The Basel Committee's words seem like the voice of a lost age. “Market discipline imposes strong incentives on banks to conduct their business in a safe, sound and efficient manner, including an incentive to maintain a strong capital base as a cushion against potential future losses arising from risk exposures.”

The committee made this statement in 2001  only 13 years ago. Even then, it was more an article of faith than an empirical observation. Very few would make such a claim today.

Instead, it is accepted that "market discipline" often lets banks run amok and that regulators need to set capital levels with a firm hand.

The Basel II recommendations introduced Pillar 3 disclosure standards to bring about such market discipline, but it didn’t help. 

The global banking system fractured and broke and has since been remade. Many businesses that existed before the crisis still exist, but the regulation of banks, as well of their clients elsewhere in the financial system and the tools they use to transfer risk, has been vastly extended.

New forms of liquidity and capital regulation and of restrictions on market structures, derivatives, securities settlement, benchmarks, commodities, market abuse, insurance, trading, hedge funds, prospectuses, resolution and securitization have been introduced.

But laughably little has been done to improve investors' information about the banks they are funding.

The largest concrete change has been the move to IFRS 9 accounting standards. The shift is a concrete one, forcing banks to treat expected losses more severely and allocate more capital to their lending. But it is so far down the regulatory agenda that it will not be introduced until 2018.

By then, European investors in bank debt will have had three years in the firing line for recapitalising banks.

From January 1 2015, resolution authorities (national supervisors or the European Central Bank) will be able to write down bank debt under new statutory powers granted by the European Union's Bank Resolution and Recovery Directive.

Bank debt investors will be providing “gone concern loss-absorbing capital” for the European banking system, whether they like it or not. But they will have to take the risk while relying on old accounting, supplemented by the Pillar 3 disclosure standards drawn up from 2001.

Enter the Comprehensive Assessment. Bank management teams will be waiting nervously by the phone on Friday. Although they have been intimately involved in the Asset Quality Review (which standardises and categorises bank assets) and the stress tests (which simulate the effect of various shocks to a bank balance sheet), they have not seen them put together.

The European Central Bank and the European Banking Authority have been working on putting the two parts together for the past couple of months  using the data from the AQR to modify the working of the stress test, and come up with a new assessment, based on a deep dive into loan books rather than on banks’ own reporting.

Banks might have a shrewd idea how they have done in each individual part but will only get the final results on Friday, two days before they are published to the market.

The scale of the exercise is such that regulators' own resources have been overwhelmed. The big accounting and consulting firms have deployed thousands of people to support them  E&Y alone had more than 2,000 people allocated to it.

Once the initial excitement of passes and fails washes out, bank analysts, managements, journalists, investors and any other interested parties will have a treasure trove of data to look at concerning European bank balance sheets and how potential stresses might affect asset books.

This will all be in standardised, comparable, machine-readable format and represents a huge expansion in the information available to investors.

Banks have proved themselves past masters at manipulating reporting requirements, making the standardisation (and its verification by the AQR) all the more important.

Previous rounds of stress testing failed for several reasons. Most obviously, the tests failed to restore confidence in the banking system because banks that had passed collapsed a few months later. 

But in the longer term, these exercises failed because they offered so much less to investors. Analysts had a few months of playing with the numbers, but their inputs were the publicly disclosed bank balance sheets  disclosure hardly worthy of the name.

Transparency does not guarantee safety, of course. Often forgotten is the fact that the US subprime mortgage-backed securities market before the crisis offered some of the best loan-level data in the whole securitization market.

But put cynicism and carping aside. The Comprehensive Assessment deserves the hype and is a big step forward for investors in European banks.

By Owen Sanderson
21 Oct 2014