The European Central Bank’s (ECB) comprehensive assessment into the Eurozone’s biggest banks brought assurance to investors but leaves the accounting profession in two minds as of the future of European banks solvency.
Twenty five out of 130 of the Eurozone’s biggest banks have failed the ECB’s comprehensive assessment and combined have registered a capital shortfall of €24.62bn ($31.36bn). Amongst the failing organisations is the world’s oldest bank, Banca Monte dei Paschi di Siena.
This was the ECB’s first review of the Eurozone’s major banks and was conducted ahead of it taking over as the primary regulator on 4 November.
The ECB released its findings simultaneously to the European Banking Authority (EBA) own review which included banks not in the Eurozone and which came up with similar conclusions to the ECB’s test.
The ECB’s comprehensive assessment combined an asset quality review, which is an evaluation of the current situation of banks based on their audited financial statement for FY13, and two sets of stress tests projecting that data against adverse scenarios, one mild and one severe.
Even though nearly one in five banks failed the assessment, the exercise brought confidence to European investors as the stress tests are not meant to reflect the banks’ current financial situation nor their financial position in a likely future scenario.
"Thus failing a stress test only really serves to indicate that the bank needs to raise more capital to ensure investors’ confidence in itself and the wider system," ACCA technical director Sue Almond. "It doesn’t indicate that the bank is insolvent, or poorly managed, or likely to get into trouble."
ACCA senior economic adviser Manos Schizas added: "And even some [banks] that have nominally failed the stress test have raised enough equity in the period between the final data submission and the announcement of stress tests to scrape through."
Indeed in that period, 12 of the 25 banks that failed the assessment have raised enough capital to cover their shortfalls, and the combined shortfall has shrunk from €24.6bn to €9.5bn.
However some criticism remains as to what was tested and the significance of the results. "The data is provided by the audited income statements and balance sheets that banks published themselves," Sikka said.
This is highly problematical according to him as the accounts are prepared under IFRS and muddied by recognition of unrealised profits, fair value debates and others.
He pointed to the UK parliamentary commission on banking standards which in June 2013 concluded that flaws in IFRS mean they are not fit for regulatory purposes and recommended that banks prepare two sets of accounts, one for investors and one for the regulator.
"They say it’s not useful for regulatory purposes and here is the EBA doing exactly that," Sikka said.
However Almond opposed that regulators have access to additional information. "The IFRS accounts are just part of the picture," she said. "The financial regulators already have a lot of powers allowing them to ask for additional information."
Another criticism raised by the profession is that the ECB’s tests were too rosy. "Famously officials refused to consider a deflation scenario, which would have severe implication on non-performing loans, even though deflation is almost certainly a fact in the Eurozone right now," Schizas said.
He also criticised the ECB for not adopting a definition of capital fully compliant with Basel III, a global voluntary regulatory standard on bank capital adequacy, stress testing and market liquidity risk adopted by the Basel Committee on Banking Supervision in 2011.
"Had the ECB’s tests been fully compliant with Basel III, more banks would have failed," he said.
Despite the criticism, CFA Institute director of financial reporting policy Vincent Papa said the ECB’s assessment was an important first step towards bank transparency and comparability across the Eurozone. "We hope this is not a one off and it will follow through with the publication of the banks 2014 financial results," he said before suggesting that the level of comparability should improve further.
"I think both tightening the harmonised requirements as well as having stronger and consistent enforcement will help create more comparable financial statements across different countries," he concluded.