ECB Asset Quality Reviews

February 2015  |  10QUESTIONS  |  BANKING & FINANCE


FW speaks with Dr James Dimech-DeBono, a senior managing director at FTI Consulting, about the European Central Bank’s Asset Quality Review process.

FW: What is your opinion of the European Central Bank’s (ECB’s) Asset Quality Review (AQR)? Do you have any concerns about the methodologies or rationale employed? Can banks in Germany and Malta, for example, truly be compared?

Dimech-DeBono: The AQRs were aimed at reviewing the carrying value of assets of the participating banks’ balance sheets as of 31 December 2013 in order to ensure that such banks were adequately capitalised and could sustain a reasonable degree of financial stress. The participating banks were chosen on the basis of three distinct criteria – firstly, the total value of the bank’s assets, secondly, the ratio of the bank’s total assets to GDP, and finally, the fact that the bank qualified as one of the three largest credit institutions in a participating Single Supervisory Mechanism (SSM) Member State, regardless of size. The ECB employed a risk-based approach on a sample portfolio of assets. This was designed to focus the detailed analysis of the AQR on those portfolios most likely to have a material misstatement on a bank’s balance sheet. The rationale behind the AQRs and methodologies employed were sound enough in principle. However, the exercise itself only represented the first step – the follow-up is arguably the most important stage. The ECB wanted to have an ‘independent’ view on the quality of banks’ balance sheets. The implication of all this brings into questions the quality of the reviews at the member state level, as well as the statutory audits. In other words, the ECB established a single supervisory mechanism in order to get its own independent and unbiased view of the banking system and assess the systemic risk within the Eurozone. Regarding the methodology itself, while sound in principle it was rather a ‘one size fits all’ solution and to a certain extent some aspects were refined through the exercise. The quality of the information, its availability and the systems used to capture the data have been challenging to the implementation of the ECB’s methodology. However, it is important that lessons were learnt which will have an impact on future reviews.

FW: To what extent do the baseline and adverse scenarios introduced in the stress test and AQR really reflect the kind of risks and ‘worst case scenarios’ banks may face in the future? Do you believe they are a legitimate way of testing the strength of the EU banking sector?

Dimech-DeBono: Stress testing has been at the fore since the financial crisis of 2008. As such, banks applying for state aid in 2009 were required to stress test the portfolios they were ring-fencing. The starting point was to first arrive at a normalised valuation and then introduce stress scenarios. Getting to a normalised valuation setting was defined by the European Commission (EC) as the “true economic value”. An additional difficulty in attaining such a setting is determining how to achieve this across different countries in a consistent manner, in order to ensure that no bank receives favourable treatment just for being in a particular jurisdiction. It was a challenge back then and remains a challenge when dealing with different economies today. The ECB’s stress test exercise in 2014 consisted of two macroeconomic scenarios, namely a baseline scenario and an adverse scenario. The baseline scenario was based on the EC’s winter forecast, extended to cover the third year of the stress test – 2016 – and was supposed to reflect the most plausible scenario. The adverse scenario captured the prevailing view of current risks facing the financial system in the EU, as identified by the European Systemic Risk Board (ESRB). The adverse macroeconomic scenario covered the horizon 2014-16. The aim of the exercise was to produce paths for macroeconomic and financial variables such as GDP growth, harmonised consumer (HICP) inflation, unemployment, interest rates and stock prices in terms of deviations from a given baseline. The explored stresses were generated to cover four sources of risk. The approach broadly provides for the type of macroeconomic risks that banks can be exposed to. Specific vulnerabilities and risks of each bank and country were not necessarily fully evaluated in the exercise. Each country within the EU has its own macroeconomic parameters and thus it is difficult to establish consistent stress scenarios across countries. One must bear in mind the fact that certain economies, and indeed banks, were already operating under ‘stressed’ conditions. Whether the ECB covered a worst case scenario remains an open question.

The exercise itself only represented the first step – the follow-up is arguably the most important stage.
— Dr James Dimech-DeBono

FW: Which area represents the greatest risks for banks – book values or non-performing exposures?

Dimech-DeBono: The AQR manual imposed a standard definition for non-performing exposures and described these as any debtor with one or more facilities that fulfilled any of the following criteria: Firstly, every ‘Material’ exposure that is 90 days past due, even if it is not recognised as defaulted or impaired. ‘Material’ is defined as per Article 178 of the CRR and respects national materiality thresholds. Secondly, every exposure that is impaired, respecting the specifics of GAAP versus IFRS banks. Finally, every exposure that is in default according to CRR, defined as ‘unlikely to pay’. When considering the values those assets were booked at, the question remains: when was the last time that these values were updated? Any valuations performed earlier than the last 12 months had to be revised. It is important to have these valuations updated as it is only then that a bank is able to estimate an accurate loan-to-value (LTV) in order to determine its exposure. From a risk perspective, the bank can easily manage the book value risk as it is within its control to get an independent valuation, but the non-performing aspect depends more on the bank’s customer. However, close account monitoring can help to manage this risk, which includes monitoring covenants and so on. In other words, banks always need to have updated information at hand, no matter what. This remains imperative, representing the ‘gold standard’ of risk management. Unless book values are updated and loan performance is assessed, provisioning may be inadequate and as result the health of a bank may be misstated.

FW: To what extent was ECB documentation such as the AQR manual (Phase 2) helpful during the supervisory process? How useful will the manual be going forward?

Dimech-DeBono: The Phase 2 manual provides clear enough guidance for the different phases of the AQR process. The information is helpful for the way the AQR process has been defined. Considering that this was written with a specific audience in mind – namely auditors rather than risk professionals – it had to achieve certain objectives. Such objectives included being prescriptive and simple enough for auditors to be able to implement the process. Too much prescription and simplicity, however, can have several drawbacks and can render the effectiveness almost irrelevant. Furthermore, the ‘one size fits all’ approach is another drawback, and lessons have been learnt from such an exercise. For example, while standardised templates were necessary, a certain degree of flexibility in collateral classification and description would have been helpful in drawing distinctions between the larger and smaller Eurozone members. As noted, this represents the first step in an ongoing process, and given the limitations that the first exercise was conducted under, it is likely that feedback will be taken on board and improvements to the process will be made. The process is also likely to have better coverage – that is, it is likely to include more banks to ensure proper risk management across the Eurozone.

FW: Does the outcome of the stress test and AQR represent a paradigm shift for European banks? Is there a new level of transparency?

Dimech-DeBono: For certain banks, this has certainly been the case. It was quite the rude awakening compared with historical standards they needed to adhere to. Furthermore, it represented a shift in their way of thinking that was otherwise not being captured through both the regulatory assessments and the statutory audits. In this respect, both local regulators and auditors need to take the AQRs into account and revise their practices accordingly. Both these parties came out of the financial crisis unscathed, when this should not have been necessarily the case. But this process should ensure that they reassess their practices and ensure that they have the right competencies and expertise when looking into financial institutions in the future. I believe that the same findings apply here as those reported by the Federal Reserve in the US. In many cases, along with taking steps to boost capital, banks have needed to make significant investments in risk management, valuation, liquidity assessment and modelling tools, as well as in the infrastructure required to support these kinds of high-performance systems. Regulators and auditors alike need to ensure that they can cope with these changes as well.

Unless book values are updated and loan performance is assessed, provisioning may be inadequate and as result the health of a bank may be misstated.
— Dr James Dimech-DeBono

FW: Was the one-year AQR timetable too restrictive? How does a short-term focus translate into long-term planning?

Dimech-DeBono: The one-year AQR timetable was a good starting point. Going beyond that point, issues with data quality and availability would have caused even more problems for some of the banks. As long as constant monitoring is carried out on an annual basis, to ensure that there is no deterioration in a bank’s financial health and that the bank is adequately capitalised, this should be fine. However, this does not mean that the bank just manages with a short-term focus as its planning cycle will still be adhered to. Planning and risk management go hand in hand, and best practice would suggest that when a bank is looking at its long term strategy it should address this within its risk management framework starting from an analysis of its risk appetite that then cascades into the full blown risk management framework.

FW: As the AQR was a targeted, risk-based exercise, specific to institutions, how can results be extrapolated to banks that were not similarly reviewed?

Dimech-DeBono: The results cannot be extrapolated to portfolios that were not selected for review or banks that did not form part of the sample. The information gathered and analysed in detail pertains to each individual bank. Asset classes within the different banks, and the composition of portfolios, would be different as well as the individual performance of the assets. At a macro level, the only level of commonality that exists revolves around the overall assumptions that are used for the base and stress scenarios – however, other than these factors it would be erroneous to assume otherwise. While the focus of such an exercise was to choose banks using a number of criteria, future reviews should include a broader sample, if not all banks. This is not just an issue of arriving at a complete picture; such scrutiny would ensure that most, if not all banks have better risk management practices and adequate capital to conduct their business.

FW: What issues and challenges might banks face when they submit their capital plans to the Single Supervisory Mechanism (SSM)? Is the time being given to banks to fill their capital holes sufficient? Could financial stress re-emerge?

Dimech-DeBono: Thus far the banks in question have been proactive in submitting and initiating their capital plans a few weeks after the ECB published the results for the stress test. According to the Aggregate Report on the Comprehensive Assessment of the ECB, across the SSM, banks have undertaken a number of actions prior to the announcement of the comprehensive assessment results. These actions have included CET1 issuance, the conversion of hybrid instruments, AT1 issuance and repayments. Some of these banks have sought to address the issue of raising capital prior to the publication of the ECB’s report on the AQRs. A total of about €18.6bn was raised up to the publication of the AQR report in October 2014. The total raised left a CET1 shortfall of €9.5bn. In essence, banks have been proactive in this process right from the onset. Looking at the amounts that need to be raised, these are not necessarily sufficiently large amounts to expect financial stress to re-emerge. Specific issues with certain institutions may make it difficult for them to raise funding, and some of the most typical options may not be available to them as a result. From a timing perspective, shortfalls need to be addressed in the short term and unless this happens, questions may be raised as to the viability of the affected banks. Such banks then need to look forward to implementing better risk and capital management frameworks in order to avoid similar situations reoccurring. One way of avoiding going to the markets is through restructuring and raising funds through asset disposal. The restructuring plan of the National Bank of Greece, for example, included the sale of a minority stake in Finansbank, the sale of the Astir hotel complex, and the sale of 100 percent of NBGI Private Equity. Under stable economic conditions the measures undertaken by the Greek National Bank are unlikely to cause financial stress to re-emerge. In unstable conditions, the smallest spark can ignite a new wave of financial stresses on the banking system.

Having a single supervisory body ensures independent and consistent supervision across the board. The results of the AQRs validate this assertion.
— Dr James Dimech-DeBono

FW: As the scope of the SSM develops, what do you believe should be the focus? Will it achieve supervisory credibility?

Dimech-DeBono: The main focus should be, without any doubt, establishing and implementing supervision of the banking system in order to ensure its financial stability. In order to achieve the SSM, a system of common banking supervision is likely to be put in place within the EU – a system that involves national supervisors and the ECB. The ECB should function as the final supervisory authority while national supervisors perform a supporting role. High on the agenda is obviously establishing the regulatory reporting requirements to ensure consistency and further transparency. If we are to refer to the AQRs, I would expect the methodology to be refined further as a result of what was learnt during the first exercise. With regard to future stress testing, it would be useful to have additional macroeconomic scenarios available – not only conducting an adverse scenario but also conducting severely adverse or moderately adverse scenarios in order to understand the performance of banks in different macroeconomic scenarios. It would also be useful to be able to examine a country and its banks specific stresses in order to account for specific national vulnerabilities and risks. In addition, it is likely that going forward the net will be cast further and will include other banks that were not included in the 2014 AQRs. Most notably, AQRs would hopefully be performed for medium and small banks. This would ensure that even these banks would have the same risk management ‘gold standard’. The results of the AQRs are in themselves a testament to achieving this single supervisory role and have established the SSM as a credible alternative to individual regulators across the Eurozone.

FW: In your opinion, what are the main lessons to be drawn from the AQR and stress tests?

Dimech-DeBono: Given the findings from the AQRs, it became evident that there were some regulatory ‘inefficiencies’, as a number of banks were inadequately capitalised. Having a single supervisory body ensures independent and consistent supervision across the board. The results of the AQRs validate this assertion. Furthermore, the fact that the ECB put the focus on non-performing loans, and applied the new European Banking Authority (EBA) definition that would impact banks for reporting on 31 December 2014, forces banks to reclassify more loans as non-performing. This, together with the fact that the AQRs put substantial scrutiny on credit files – more than ever before – will drive banks to take action and accelerate loan sales. The success of any AQR is heavily dependent on data availability and data quality. Looking across the board, more investment is needed by banks to ensure that they have relevant and up-to-date data and systems that can be interrogated to fulfil the requirements of such reviews. Given the amount of resources required to conduct this exercise, such investment in data and technology would certainly make life easier for similar exercises. Benefits would also include having a better risk management system with good quality and clean data. Refining the methodology, including data collation as a result of the differences between countries, is another aspect that to an extent had to be dealt with. For example, definitions of property location and classification can vary quite significantly between the larger European countries and the very small ones, and these are intricacies that need to be addressed. Another aspect around the methodology is probably to break down further stress scenarios, that is, increase further the number of stress scenarios.


Dr James Dimech-DeBono is a senior managing director in FTI Consulting’s Economic and Financial Consulting segment in EMEA. At FTI, Dr Dimech-DeBono’s focus is on the financial services sector with a particular emphasis on risk management and the valuation of complex assets. He has more than 25 years of advisory experience, working with clients ranging from banking institutions to investment managers and regulators in the areas of valuation, risk management and hedging. Dr Dimech-DeBono has led a number of European Central Bank AQRs across the Eurozone, providing technical and quantitative expertise to various regulators. He can be contacted on +44 (0)20 3727 1731 or by email:

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Dr James Dimech-DeBono

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