From the highly anticipated release of the European Central Bank’s (ECB) asset quality review (AQR) and stress test results to identify capital shortfalls among banks, we know that 25 banks received failing marks and are expected to raise €25 billion of capital. The comprehensive assessment was conducted on 130 banks that hold 81% (€22 trillion) of EU banking union country bank assets. As highlighted in an earlier blog post, the assessment is aimed at restoring confidence in the banking sector and paving the way for the ECB’s banking union-based Single Supervisory Mechanism mandate.

The asset quality review results, apart from helping to determine the capital adequacy of banks, also inform on the veracity of reported bank balance sheet book values as of 31 December 2013. It is fair to say that while industry watchers will require time to fully digest the aggregate and bank-specific outcomes, an early bite of the AQR findings largely confirms the hitherto held assumption that EU bank balance sheets were overvalued in recent years because of delayed loan write-downs (see recent CFA Institute research). The review required a gross downward adjustment of carrying values to the tune of €47.5 billion, and the bulk of these were due to additional loan provisioning (€42.9 billion). The capital impact, after tax and risk offsetting, is €33.8 billion.

The results also shed light on challenges that arise in response to diverse practices around classifying loans as nonperforming and inconsistencies in the valuation of illiquid financial instruments reported at fair value (i.e., Level 3 exposures or those without liquid markets for which pricing models rely upon unobservable parameters). Although there is valuation risk associated with fair value, most of the additional write-downs were due to loan assets that are measured at amortised cost.

The asset quality review results are detailed in Chapter 6 of the aggregate report. Table 14 in the report provides a breakdown of significant adjustments (i.e., over €1 billion) by banks from Greece (4), France (4), Italy (3), Germany (2), Netherlands (2), Portugal (1), and Austria (1). The biggest adjustment (€4.2 billion) was by Banca Monte Pasch di Siena. We highlight some of the other interesting findings.

Incremental Loan Provisioning and Nonperforming Loan Exposures

The asset quality review required an additional loan provisioning (€42.9 billion) and increase in the nonperforming loan exposure (€135.9 billion). A disaggregated analysis further shows the following:

• Italian banks had the lion’s share of the additional loan provisions (€12.1 billion), with other notable mentions including Greece (€7.6 billion), Germany (€6.7 billion), France (€5.6 billion), Spain (€3.0 billion), and Austria (€3.0 billion).
• Based on the review of a credit file (85,857 debtors) there was an increase in specific and projected provisions of €26.8 billion including those related to the following categories: small and medium enterprises (SMEs), real estate, large corporate loans, shipping finance; the latter was of particular concern in Germany.

For AQR purposes, the ECB applied a consistent definition of nonperforming exposure (i.e., either 90 days past due, impaired under IAS 39 or national, or any exposure that is in default under the capital regulation requirements). The review of bank classification policies found that 28% of banks were less conservative than the ECB-applied definition in classifying loans as nonperforming loans.

Application of Fair Value Hierarchy and Level 3 Fair Value Assets (Valuation Risk)

The review of fair value classification and valuation focused on a sample of level 3 exposures. In all, 5,000 nonderivative securities values were verified. The results highlight the valuation risk associated with illiquid financial instruments and find a required write-down in carrying value (€4.6 billion). A significant proportion of the additional write-down was due to derivatives counterparty valuation adjustment (CVA): €3.1 billion.

The qualitative review of valuation policies and processes showed the following:

• Only 67% of sample banks had a clear policy for classifying active markets, with only 72% having a clear policy for defining level 3 inputs.
• 50% of banks had substandard practices in CVA calculation.
• 23% of banks had substandard practices in independent price verification processes.
• ECB disagreed with 10% of reclassified fair value assets

The combination of the above factors would likely contribute to inconsistencies in valuation of securities across banks.

Downward Adjustment of Collateral Values

Collateral-held values are not reported as part of the bank balance sheet but affect recovery and loss given default assumptions and loan provisions. A total of 170,000 collateral items were reviewed and a €39 billion downward valuation adjustment was required. The collateral revaluation was mostly attributable to commercial real estate (€11.6 billion) and land (€9.5 billion), with the collateral located in the East-Central European (€4.3 billion) and Mediterranean (€28.2 billion) regions most affected.

Which Questions Remain Unanswered by the Asset Quality Review?

Some key risk areas (e.g., litigation risk, other valuation inconsistencies such as debit valuation adjustments, valuation of level 1 and 2 fair value exposures) were excluded from the scope of the AQR. In addition, there is no bank-specific level report on the outcomes of the qualitative review of policies and processes. Such a report could have helped investors assess the extent to which individual bank accounting systems may have an impact on information risk (e.g., derivatives valuation risk, misclassification across fair value hierarchy). Furthermore, as noted previously in this space, it is not clear whether the effects of the AQR-related adjustments will be clearly presented or disclosed in the 2014 financial statements — the latter of which is an issue in some adjustments (e.g., shipping finance exposures) and reflects a prudential approach rather than one that necessitates accounting adjustments.

That said, we must give an early nod of approval to the ECB for the transparency and comprehensive reporting of the asset quality review and stress tests. The aggregate ECB report has applied adverse stress scenarios; clearly identifies banks with capital shortfalls; highlights AQR adjustments by bank; explains the nature and drivers of valuation adjustments; and points to some areas where there are shortcomings in the valuation and accounting policies and processes of banks. In this regard, the assessment is a step in the right direction, and it bodes well if supervisory oversight can encourage more consistent reporting of nonperforming loans exposures and other challenging areas such as derivatives CVA. Nevertheless, this focus on improving the transparency of bank reporting needs to be sustained — if it only is a one-off exercise, it is not likely sufficient to build investor confidence in the transparency of bank reporting.