UK: Preparing For The SSM - How Should Eurozone Banks Mind The (Capital) Gap?

Last Updated: 11 July 2014
Article by Simon Brennan and Dea Markova

Most Read Contributor in UK, August 2017

The next few months will barely feel like a summer holiday for Eurozone banks. As banks in the single currency area prepare for the European Central Bank (ECB) to take over banking supervision under the Single Supervisory Mechanism (SSM), the balance sheets of the largest banks are being reviewed and stressed as part of the ECB's comprehensive assessment. In October, the results – based on an asset quality review (AQR) and EU-wide stress test - will be revealed. 

For some banks there will be shortfalls in regulatory capital to remedy immediately. For others, the exercise may highlight balance sheet adjustments that need to be made, or point to shortcomings in governance or processes that need to be addressed. The message from the ECB has been clear – the assessment needs to be credible, and therefore conservative in its assumptions. Danièle Nouy, Chair of the SSM, said earlier this year that it had to be accepted "that some banks will have no future".

Sabine Lautenschläger, SSM Vice-chair, made clear that the ECB expects banks anticipating capital shortfalls "to have their solution ready before [the ECB] publishes the results. It is the only way to avoid unnecessary market uncertainties". There is evidence of banks already having taken measures to clean up their balance sheets, for example, through the creation of a 'bad bank' or the sale of non-performing loans earlier in the year.

As the comprehensive assessment nears completion over the next few weeks, banks should be firming their view of the possible outcomes for them, and taking steps to plan as appropriate. Although banks will not see the results of the AQR directly, data requests made by the ECB over the course of the AQR – and banks' experience trying to meet them – may already have highlighted potential areas of concerns that SSM supervisors could follow-up. Since banks are running the stress test exercise themselves, they have full visibility on the outcome.

The results of the Comprehensive Assessment will be disclosed in a report at the end of the exercise, with outcomes presented at the level of individual banks. Banks will be able to trace any identified capital shortfall to its cause, i.e. the supervisory risk assessment, AQR or stress test. Additionally, the results will include an assessment of policies and processes at each bank.  For some banks, shortcomings identified may help to explain how a capital shortfall developed in the first place.  

In our latest paper on the SSM, Mind the (Capital) gap, we examine the options available to banks looking to remedy a capital shortfall. None of the options is simple; all of them may be particularly hard to execute against the backdrop of a Eurozone-wide exercise, where several other banks may be taking similar action, and where banks are having to improve capital levels in response to identified weakness. In some countries the options may be limited by the investor base or market depth. Furthermore, regulators or governments may seek to influence the chosen course because, for example, of a view on how best to deleverage in order to manage the effect on the economy.

The cause of the shortfall identified will determine how long a bank has to remedy it – a shortfall against the AQR and baseline stress test will have to be addressed in six months, a shortfall against the adverse stress test scenario – in nine. In the paper we consider four alternatives:

Capital issuance

ECB statements suggest a strong preference for equity issuance, particularly with regard to a baseline or AQR capital shortfall. The summer is likely to see a number of banks tap investors ahead of the comprehensive assessment results.

Hybrid capital is an alternative option to fill a capital shortfall.  Such convertible debt is seen by some as an attractive way to boost Tier 1 capital without diluting existing shareholders, and the tax deductible nature of the interest payments is also very appealing to many banks.

Asset sales

This can be a relatively rapid route to balance sheet reduction and, done appropriately, of remedying a capital shortfall. It should be relatively popular with shareholders as it indicates the bank taking an active approach to cleaning up its balance sheet.  The challenge may be that in some jurisdictions the key infrastructure for asset sales are missing, or the investor base is relatively underdeveloped.

De-risking and capital optimisation

Many banks have already begun to assess the capital consumption and profitability of the different parts of their business given the increased regulatory focus on capital levels.  The challenge in adopting this strategy at the end of the comprehensive assessment may lie in the fact that the nature of some assets precludes a quick exit.

Mergers and acquisitions

Members of the ECB have clearly identified scope for consolidation among European banks.  However, business combinations take both time and expertise to execute successfully and the Banking Union timetable for remediation is challenging. In addition, at the national level there may be a number of challenges which impede consolidation.

If a bank ultimately decides to re-shape its business in response to the comprehensive assessment, this should be done as part of a longer-term strategy to transform its business model.

What is certain is that banks will be in a stronger position the earlier they plan. For those banks found to have a capital shortfall, it will be essential to have a plan in place by the time the results of the comprehensive assessment are announced.

Banks should also take the opportunity to gather insights from the comprehensive assessment into the ECB's proto-supervisory approach to data and supervision, and to embed any necessary changes into their SSM preparations. The AQR has exposed material gaps in data coverage, completeness, quality and consistency at some banks. It should be expected that these data standards will become business as usual in the SSM. More generally, banks should anticipate rigorous scrutiny over their balance sheets and business models and a more quantitative approach to risk assessment.

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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