UK: Asset Quality Review - European Central Bank Unveils Ambitious Plan

Last Updated: 28 October 2013
Article by Deloitte Financial Services Group

Most Read Contributor in UK, August 2017

Before the European Central Bank (ECB) formally takes responsibility for bank supervision under the Single Supervisory Mechanism (SSM) – expected to be from November 2014 – it will conduct a thorough review of the assets of the banks that it will directly supervise.  The comprehensive assessment, as it is called, nominally has three goals: to deliver greater transparency on balance sheets; to prompt the repair of impaired balance sheets; and to rebuild confidence in banks.  More fundamentally though, the ECB considers the exercise essential, so that it can begin its supervisory confident in the knowledge that the major banks are on a sound capital footing. 

The ECB today (23 October 2013) published details of the assessment exercise and the banks affected. This is essential reading for anyone with an interest in the banks concerned. The exercise is significant in size and scope.  Banks will need to start preparing now and for many the exercise will consume significant management and financial resources.

Between November 2013 and October 2014, the ECB will conduct a comprehensive balance sheet assessment of the 124 most significant Eurozone banking groups (representing approximately 85% of Eurozone banking assets), working closely with National Competent Authorities (NCAs) and cooperating with the European Banking Authority (EBA) to conduct a stress test.

At the core of the exercise is an asset quality review. Based on balance sheets as at 31 December 2013, the assessment will cover credit and market, on and off balance sheet, domestic and non-domestic exposures.  The review will focus on the riskiest areas of the balance sheet.  It will use harmonised definitions and 'a conservative interpretation of IFRS'. It will include data integrity validation, sampling of target portfolios, an assessment of the adequacy of valuation, classification of non-performing exposures, collateral and provisioning; and possible adjustment of risk-weights.

On completion of the asset quality review, banks will be judged against a capital threshold of 8% based on CRD IV definitions as at 1 January 2014. Where necessary, the results of the exercise will be followed by corrective measures – for example, recapitalisation, deleveraging or improving funding resilience. The possible need to rely on public backstops is explicitly referred to (but interestingly the text is silent on bail-in).  The timelines for implementing such measures will be part of the outcome of the assessment. 

Next steps

Banks will be invited to a meeting in Frankfurt to hear further details about the process, and will also be asked to provide further information via their NCA. The process of portfolio selection will start in November 2013.  Information on the stress test methodology will be published at a later date.

Prior to SSM implementation in November 2014, outcomes aggregated at country and bank level will be revealed, together with any recommendations for supervisory measures.

This remainder of this blog post highlights the key points from each stage.  The full report from the ECB, including a list of the banks, can be downloaded here

The Comprehensive Assessment in a nutshell

The Comprehensive Assessment will have three stages: 

  1. Supervisory risk assessment: analysis based on backward and forward looking information of a bank's intrinsic risk profile, peer group positioning and vulnerability to exogenous factors. The ECB and NCAs are developing a risk assessment system for the SSM, which will also be used for this stage of the assessment, in parallel with national risk assessment systems.
  2. Asset quality review: based on end-2013 data, it will include credit and market exposures, on and off-balance sheet positions and domestic and non-domestic exposures.  All asset classes will be in scope.
  3. Stress test: the EBA and the ECB will perform the next EU-wide stress test in close cooperation across all 124 banking groups. Further details will be published at a later date.

The ECB will conduct the Comprehensive Assessment in close cooperation with NCAs.  The ECB will provide the blueprint for the assessment, monitor its execution and perform on-going quality assurance.  NCAs will execute the exercise, with the support of private-sector expertise.The exercise will be consistent with the EBA recommendation on the conduct of asset quality reviews.

Which banks are included?

The 124 banking groups have been selected based on criteria in the SSM Regulations for identifying 'significant' banks.  Notably, since the banks will be supervised and assessed at the highest level of consolidation in participating Member States, subsidiaries of Eurozone banking groups are not listed individually, unless they are one of the three biggest banks in any Member State.

This initial list underscores that the exercise is relevant to banks headquartered outside the Eurozone, including the UK, the US, Switzerland and Sweden.  For example, subsidiaries of Bank of New York Mellon, Bank of America Merrill Lynch, HSBC, State Street, UBS and RBS are on the list.

A full list of the banks can be found in the report.  The list of banks is preliminary. The final list will be compiled in 2014 when up-to-date statistics are available. Provisions in the SSM Regulations which allow for a supervisory judgement on which banks should be considered significant will also be made at a later stage, once the SSM framework regulation is published.

The ECB note that Eurozone countries currently engaged in similar bank review processes may benefit from those processes, but they are not a substitute for full participation in the comprehensive assessment.

Key asset quality review details

The asset quality review will focus on the elements of banks' balance sheets which are considered most risky or non-transparent, subject to minimum coverage and sampling requirements.  It will have three stages:

  1. Portfolio selection: NCAs will propose – and the ECB will review and challenge – the portfolios to be included the portfolios to be included in the assessment. There will be minimum coverage criteria at the banks and country level.
  2. Execution: This stage will include data integrity validation, assessment of the adequacy of banks' asset valuation, classification of non-performing exposures based on EBA
    definitions, collateral valuation and recalculation of provisions for risk-weighted assets.
  3. Collation: A final consistency check to ensure comparability of results across all banks.

While a full assessment of internal models used for the calculation of risk-weighted assets will not take place within the time frame of the exercise, the outcome of the exercise will lead to adjustments in the risk-weights, where justified.

The ambitions of the AQR exercise point to another issue of relevance to non-SSM countries and banks: should the assessment reveal valuation discrepancies for assets held elsewhere in the Group, the relevant supervisors may need to take note of these conclusions.  

Eurozone banks after the AQR

A capital benchmark of 8% Common Equity Tier 1 (CET1) will be set for the asset quality review, which the ECB explains as comprising the CRD IV 4.5% CET 1 minimum requirement and 2.5% Capital Conservation buffer, along with a 1% add-on to proxy for the systemic risk buffers.  The definition of capital will based on 1 January 2014 definitions.

Although the size of the benchmark is based on CRD IV requirements, it has the effect of foreshortening the transition period.  Under CRD IV none of the CET 1 minimum requirement, the Capital Conservation buffer or the systemically important institution buffers will be required in full by 1 January 2014. 

This accelerated pace may be challenging for some banks.  In its latest Basel III monitoring exercise, the EBA found that whilst 44 of the European Union's biggest banks (12 of which are not in the Eurozone) would hold 8.4% CET1 in aggregate on a fully-loaded CRD IV basis, the less well capitalised banks in the sample would in aggregate need to raise EUR 70.4 billion to meet a 7% threshold. This points to recapitalisation being a likely outcome for some banks once the comprehensive assessment is concluded. In fact, the ECB highlights this outcome and indicates that timelines for any "corrective measures" will be set as part of the exercise.

The ECB expects any capital shortfalls in banks that have "viable business models but are required to build additional capital for prudential reasons" to be made up from private sources, and if possible before the conclusion of the exercise.  If sufficient private capital is not available, public backstops might need to be drawn upon.  The ECB points out that European rules require Member States to have national backstops in place.  Interestingly, no explicit reference is made to bail-in.

For more information on the SSM, please see our lastest paper on the subject, or for more information about the EMEA Centre for Regulatory Strategy, please visit 

Simon Brennan – Senior Manager, Deloitte EMEA Centre for Regulatory Strategy
Simon is a Senior Manager in the EMEA Centre for Regulatory Strategy, specialising in prudential regulation for banks. Simon joined Deloitte after 11 years at the Bank of England, where he worked in a number of areas covering macro and micro prudential policy, and financial institution risk assessment. LinkedIn.

Dea Markova - Assistant Manager, Deloitte EMEA Centre for Regulatory Strategy
Dea is an Assistant Manager in the EMEA Centre for Regulatory Strategy. Her primary areas of focus are the Single Supervisory Mechanism and international, EU and UK insurance regulatory initiatives. She joined Deloitte in 2012. She has past experience in financial journalism and an academic background in financial regulation

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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