Established in 1998, the European Central Bank, or ECB, has the primary mandate to maintain price stability within the Eurozone. In addition to monetary policy responsibilities, the ECB is mandated to oversee stability of the financial system and to monitor the banking system.
In a recent announcement, the ECB indicated it is creating a new system of financial oversight for participating European Union countries. An initial step in this evolving oversight process will be a series of tests and assessments of the balance sheet strength of approximately 130 key credit institutions.
Approximately 85 percent of euro area banking assets will be represented by these 130 financial entities. In an effort to provide a broad geographic footprint for this analysis, the focal credit institutions will come from 18 different countries. Countries where the euro currency is used are automatically included in the review process, while non-euro countries have the option to opt in. In each country, a minimum of the three most significant credit institutions will be included in the ECB’s testing process.
Three broad areas will be tested, including a supervisory risk assessment. This assessment will address the banks’ balance sheet health, liquidity position, financial leverage and funding capabilities. A second area of focus will be the quality of the assets held by the banks on their balance sheets. While the asset assessment will be broad, significant focus will be placed on hard to value assets and off-balance sheet exposures. A forward-looking stress scenario will be the third area of emphasis.
Although significant improvements in banks’ balance sheets have occurred over the past five years, material concerns remain. Transparency of risks and overall credit quality of asset portfolios are persistent concerns for investors, depositors and governments that have had to provide capital infusions to several key banks during the last financial market meltdown.
An important measure resulting from all these risk assessments will be the amount of capital held by each of these 130 key credit institutions as a percentage of Tier 1 Common Equity. Where insufficient capital exists for a given set of risks, those banks will have to undertake a series of corrective actions. Once these analyses and corrective actions have been completed, the European banking system should be on a more sound footing.
Kirby Brown is the CEO of Beneficial Financial Group, based in Salt Lake City.