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28 October 2013updated 22 Oct 2020 3:55pm

The ECB’s Asset Quality Review is a work of art – minimalist art

A masterpiece of reverse engineering.

By nick beecroft

In creating what was a potentially vital part of the project to keep the Euro afloat, the European Central Bank had a mission. They were to design a bank asset quality review that was just tough enough to gain credibility, but not too tough, for fear of scaring the horses and inducing queues of depositors to form outside banks when the results come out.

What we got was a masterpiece of reverse engineering, aimed at achieving just what was required – just enough. It can’t be denied there are some tough-sounding parts, some tidbits of rectitude – an examination of gross liquidity ratios, excessive LTRO usage, and rigorous scrutiny of off-balance sheet exposures and the risk-weightings which banks choose to apply to their assets.

We are assured these matters will all receive diligent attention in the AQR, and may even lead to a subjective decision to raise the required capital ratio above the standard level of 7 per cent, (8 per cent for large, systemically important banks). Ok, sure, we’ll wait and see what happens!

Very sensibly the AQR will take a Q4 2013 snapshot of balance sheets, so as to discourage banks from indulging in an unseemly fire sale of assets or reduction in customer loans by not giving them enough time to do so.

We even got some headmasterly rhetoric from Mario Draghi along the lines that we must have no fear, the AQR would be stringent enough so that some banks do actually fail, to ensure the process had credibility (preferably very small ones that have little chance of spreading contagion fear). He further insisted that governments must have a backstop in place. This was a thinly veiled tilt at Germany, who is in turn insisting that every cent is bled out of private bond and equity holders, of every possible description, first, before the European Stability Mechanism is tapped for bank re-capitalisation.

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The trouble is, this AQR does very little to address the potentially lethal death embrace of banks and their governments that exists as a result of the banks’ enormous holdings of sovereign bonds. This is to be expected: a proper risk-adjusted examination of the various hues of government bonds stuffed into banks’ balance sheets, with realistic risk weightings, would be far too scary and if it ever saw the light of day, and might just bring the whole Tower of Babel crashing down.

So there were are, just enough to give the banks another year to de-leverage before the European Banking Authority stress tests and, with results not due for a year, just enough time for Germany to become satisfied with the ESM’s rules of engagement.