The European Central Bank has successfully completed its comprehensive bank stress tests, designed to weed out vulnerable banks before it took responsibility for their supervision. The results show that a large majority of institutions are resistant to a worsening of the global economic situation, as well as turbulence in the financial markets.
It also became clear that the 25 banks who proved to have too small a capital cushion will be able to accommodate this point of weakness, or will address the capital shortfall before the year ends.
The stress tests awakened high expectations. Most observers believe that the process was conducted in a credible manner. The banks began preparations at the end of 2013, shortly after the announcement of the monitoring. Since then, they have come up with more than €200 billion ($249 billion) in order to improve their balance sheets: they have increased their capital, expanded the share of less risky assets and reduced their debts.
Although public interest was naturally concentrated on the precarious capital cushions, a much more important outcome is the large amount of comparable information gleaned from the balance sheets. It will give investors a basis for evaluating the stability of individual banks, bringing transparency and a long-needed strengthening of discipline in the market.
Different options for entering the value of capital resources are permitted under the current framework of European regulations, but this will change in late 2017 with the full introduction of a global standard designed to strengthen bank capital requirements, the Basel-III provisions. For deferred taxes, the transition period is somewhat longer – it lasts until the end of 2023.
The stress tests were a first step towards harmonizing the numerous possibilities of selection and areas of discretion in different countries. Now, in its new role as a supervisor of the most important banks, the ECB is responsible for further improving the standardization of financial data released by the banks. In addition, there is a need to complete the harmonization of monitoring practices.
In its supervisory role, the ECB will focus intensively on the quality of the capital that is held by the banks. In this way, it seeks to ensure fair competition, and that a race to the bottom, which could have deleterious effects on financial stability, is avoided.
The present economic situation is challenging for euro-zone banks, even if they are in a position to absorb shocks.
The present economic situation is challenging for euro-zone banks, even if they are in a position to absorb shocks. In recent years, profits have been modest, and there is reason to expect that earnings will remain moderate in the future. The double whammy of sluggish growth and flat yield curves creates a difficult situation for these institutions, because it exercises a negative influence on both credit risk and their revenues. In addition, some banks are still suffering from high financing costs and a substantial number of non-performing loans, those in or close to default.
The recent tests have highlighted the fact that large European banks are shouldering NPLs worth €879 billion. NPLs not only reduce the profitability of banks by requiring high reserves to cover losses from loans, but they also limit the capability of financial institutions to issue new, profit-making credits. For these reasons, the heavy burden of loans in default constitutes an especially serious problem which must be addressed by both the monitoring authorities and the banks themselves.
All in all, the ECB has created a positive initial environment for monitoring the most important banks in the euro zone. Standardized information with regard to banks’ balance sheets now exists. Weak points in the amount and quality of capital have been revealed, and further lessons were learned from the stress tests. This reduces the likelihood of a bank crisis in the future.
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