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Who is afraid of the Asset Quality Review? Potential Losses and Capital Shortfalls in the European Banking System

Bonczek, T., Fuest, C. & Schröder, M. (2014) "Who is afraid of the Asset Quality Review? Potential Losses and Capital Shortfalls in the European Banking System", Centre for European Economic Research, Discussion Paper No. 14-074 , October.

 

The creation of a banking union is widely seen as a key element of institutional reforms towards more financial and economic stability in Europe. Its objective is to improve the effectiveness of banking regulation and supervision and to sever the link between the finances of national governments and the banks in the Eurozone, which was a destabilising force in the European debt crisis.

A key element of the banking union is the creation of a single supervisory mechanism. At the end of 2014, the European Central Bank will take over the responsibility for banking supervision in the Eurozone. It will directly supervise the largest and systemically most important banks in the Eurozone, a group of approximately 130 financial institutions. Before assuming its new task the ECB intends to investigate the financial solidity of these banks in the framework of a ‘comprehensive assessment’. It is the objective of this assessment ‘to enhance the transparency of the balance sheets of significant banks in the euro area, and in so doing, to trigger balance sheet repair where necessary, as well as to strengthen confidence.’

The asset quality review (AQR), a review of the quality of different types of assets including underlying collateral will be the most important element of this assessment. The assessment will be combined with a stress test.

The AQR and the stress test linked to it raise a number of questions. How large will the capital shortfall be? Which banks and which member countries will be affected? How does the type and level of capital thresholds used in the stress test affect the results? How will the required capital be raised? Clearly, the answers to these questions depend on what the ECB and the national authorities participating in the exercise will find in the review. But the European Central Bank (2014a), p.14 results will also depend on the structure of bank balance sheets with current valuations. It is therefore interesting to ask whether, on the basis of publicly available information, anything can be said about the magnitude of the existing capital shortfalls that can be expected. In this paper we calculate hypothetical capital shortfalls by studying various stress test scenarios using publicly available bank balance sheet data.

 

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