We can soon expect the European Central Bank (ECB) to outline the details of the Asset Quality Review (AQR), an examination of some 130 European banks’ assets, to be conducted in 2014. The AQR may well lead to a polarisation of banks, cutting to the quick on their viability or otherwise. As such it may precede something of a cull…

Banks get tested for their ‘viability’ quite a lot don’t they?

Banks will be subject to checks against their capital, leverage and liquidity ratios under Basel III which will fully come into effect in 2009 and also subject to stress tests from the European Banking Authority, last in 2011.

Did they fail those tests?

To some people’s minds the tests failed. Seven banks did not pass, but that was fewer than had been expected, according to research by broker Goldman Sachs, which had predicted ten to fail. That said, Goldman Sachs later noted that some 13 banks had fallen within the margin of error for failure.

The real issue for many was when Belgian bank Dexia, which had passed the tests, went bust in late 2011. A holder of much government debt from southern European countries, such as Greece and Italy, the bank had been described as having sufficient capital to ‘weather’ stressful circumstances. The European debt crisis and Dexia’s subsequent breakdown demonstrated the need for stronger assessment of asset quality.

What will be done now?

On 23 September Mario Draghi told the European Parliament that 130 banks, representing 85% of Eurozone assets, will have the quality of their assets reviewed and then have stress tests applied. Seventy three people have been seconded by the ECB from national regulators to help with this process. He also said that a quarterly progress report will be sent to the Council of the European Union, the European Commission and the Parliament.  

The Financial Times reports that the AQR will focus on particular assets. One of these is real estate, which will raise interesting questions about the existing bubble in the UK market and the exposure of banks to collapsed markets like Spain and Ireland. Another set is the lending portfolio to small and medium enterprises, which governments have been publicly telling banks to expand, while not actually forcing them to toe the line. Finally, assets that originate from pre-crisis portfolios of derivative and leveraged loans will be looked at.

That sounds like we’ll have a more accurate picture?

Sure. Although the picture may not be a pretty one. Smaller banks like Monte Dei Pasche are already in trouble and need to get their act together before this happens. Even bigger banks have had their books called into question; Deutsche Bank is the subject of an investigation by the Bundesbank, Germany’s central bank, as to whether it conceal losses on derivatives positions during the crisis. If any banks are hiding guilty secrets, they may be exposed and that could be painful for Europe’s financial sector.