The European Central Bank gave more details Thursday on what is shaping up as by far the most rigorous review of the health of eurozone banks. The bank will disclose the results in late October, and then troubled lenders will have only two weeks to come up with a plan to raise new capital.
The review is part of a broad attempt to uncover hidden problems, force weak banks to rebuild their capital buffers and remove doubts about the stability of the eurozone financial system. Banks have grumbled about the immense task of compiling information for the central bank, but analysts see the review as essential to restoring the flow of credit to countries like Italy and Spain.
As publication of the results approaches, however, there is also concern that it could cause instability in financial markets if some banks turn out to be in worse shape than expected. The central bank, aided by a small army of regulatory officials and private consultants, has already compiled a huge amount of information about eurozone banks but has not given any indication of whether any are suffering from previously undiscovered ills.
ECB officials on Thursday pointed out that the review had already prompted many banks to raise capital and deal with bad loans, suggesting that the disclosures in October would not produce too many unpleasant surprises.
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“Banks know what we expect and have advance notice to prepare for the outcome of the comprehensive assessment,” Vitor Constancio, the vice president of the European Central Bank, said in a statement Thursday. “Much work has already been undertaken to repair banks’ balance sheets and, encouragingly, this work is continuing.”
The review will cover 128 of the most important banks in the eurozone. The central bank, with the help of about 6,000 officials from national regulatory agencies as well as private consultants contracted for the task, is looking at whether banks have confronted all their problems and whether they could withstand a shock, like a deep recession.
For example, the central bank is looking at whether lenders have correctly estimated the chances that a borrower might not be able to repay a loan. A bank that had underestimated its risk would be required to raise more capital to cover potential losses.
After this so-called asset quality review is complete, the ECB will conduct a separate stress test to determine whether the bank has enough capital to withstand an unexpected downturn or another financial crisis. Results of both the asset quality review and the stress test will be presented in the second half of October, the central bank said, without giving a specific date.
Banks will then have two weeks to present a plan for raising capital or taking other corrective measures. A bank that is short of capital would need to sell new shares or, if it is not able to raise money from the private sector, seek a government bailout. It is possible that some banks will have problems so severe that they will need to be shut down.
One effect of the review will be to provide investors and analysts with an unprecedented amount of information about banks’ loan and investment portfolios. Banks will be required to give greater detail than most do now on their risk from investments like government bonds, commercial real estate or the shipping industry.
Banks with problems are likely to face market pressure to take action, in addition to pressure from regulators.
European banks have been subject to stress tests before, but those tests were criticized for being too lax. Some banks that passed the stress tests, like the French-Belgian bank Dexia, ran into severe problems soon afterward.
The review of bank assets is part of the broader creation of a banking union in the eurozone, under which the European Central Bank will assume overall responsibility for bank supervision. In the past, there has been criticism that some national regulators were not tough enough on their country’s banks.