A Review of Banks in Europe Gets Results

http://www.nytimes.com/2014/03/14/business/economy/a-review-of-banks-in-europe-gets-results.html

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What is an asset worth? How much capital does a bank really have?

Since the financial crisis showed that banks in many countries had reported capital levels that turned out to be wildly optimistic, investor cynicism has grown, and with it fears that a genuinely stringent evaluation of a bank’s books could produce disastrous results. Nowhere is that truer than in Italy, where in the past national regulators sometimes appeared to be more like cheerleaders than stern judges.

A 2010 stress test of large European banks, which found they were generally in good shape, was widely derided because it assumed no risk in government bonds — the very asset that was arousing the most concern among investors at the time. Passing a test widely viewed as rigged does not add much to a bank’s credibility.

This week brought some bad news from the largest Italian bank, UniCredit, as it reported a loss of 15 billion euros — about $21 billion — in the final quarter of last year. In normal times, such an announcement would most likely prompt a sell-off in bank stocks. But this one did the opposite. Shares rose, with UniCredit climbing to a two-year high.

In buying shares, investors were in effect saying that they found the UniCredit numbers credible and that they were not nearly as bad as had been feared.

And because the announcement was widely assumed to be an attempt to get out in front of the European Central Bank, which will opine on the status of all large European banks later this year, it represented evidence that investors trust that review is being done well. Its results are expected in October, before the central bank takes over regulation of the large banks in November.

The asset quality review, and a stress test to determine how well each bank would do in a specified crisis, are being conducted by the E.C.B. in conjunction with local central banks. In a fractious Europe, the evidence so far is that the process is going well.

“By and large, talking to E.C.B. staffers and reading the documents, I think the E.C.B. is conducting a competent process,” said Jacob F. Kirkegaard, an economist with the Peterson Institute for International Economics.

He noted that Italy was the only one of the troubled peripheral countries in the euro zone that had not had its banks carefully vetted by European institutions in connection with a possible aid plan.

“It is clear,” he added, that “for political reasons, the one country where Mario Draghi cannot be seen to be lenient is Italy.” Mr. Draghi, the president of the European Central Bank, was previously the governor of the Bank of Italy, that country’s central bank. The hope is that the E.C.B. will assure consistent standards across Europe. “This is about moving from 18 supervisory approaches to one,” said Stephen G. Smith, a partner in the British affiliate of KPMG. “It represents a change for every bank. It will have consequences from a capital, liquidity and funding perspective.”

On Thursday, Mr. Draghi appeared to be claiming success though the bank review had barely begun. “Just the prospect of the comprehensive assessment has already caused banks to raise new capital and to shed noncore or nonprofitable exposures,” he said in a speech in Vienna. “This is very welcome. Corrective action does not need to wait until the end of our comprehensive assessment.”

But if the E.C.B. looks good so far, the UniCredit report also provided evidence of just how disconnected — and in some ways political — the world of European accounting has become.

The bank, which went on an ill-conceived acquisition binge in Central Europe in the years before the credit crisis, wrote off €9.3 billion in good will and customer relationships — essentially an admission that it overpaid. And it more than quadrupled its provision for loan losses, raising the figure by €7.2 billion, to €9.3 billion.

But even though the bank’s net worth on its published financial statements fell by 24 percent, bank capital is computed differently. There the decline was much smaller, and UniCredit concluded it did not need to raise capital. It even decided it could raise its dividend. It forecast a profit of €2 billion in 2014 and €7.5 billion in 2018.

The fourth-quarter loss would have been more than a billion euros larger had the bank not been able to report a profit on a presumed increase in the value of its stake in the Italian central bank. It is likely to sell a part of that stake within a few years, but it has not done so yet, and there is currently no market in the shares.

The Italian central bank has reorganized its capitalization, with new shares issued to replace old ones. The shareholders plan to raise the book value of their central bank shares to the current value.

In the absence of a market, how do they know the new value? It was set by a law passed by the Italian Parliament. A “High Level Group of Experts” — that was the official name of the group — concluded that the central bank was worth €5 billion to €7.5 billion. The Parliament chose the high figure.

Why didn’t we think of that? Instead of using many billions of dollars to bail out the banks in 2008, perhaps Congress could have simply passed a law declaring them solvent.

High-quality accounting standards, some would say, should be based on reality, not political convenience. But among European accounting regulators, there seems to be no hesitation to accept the number chosen by the politicians.

But there is a dispute over which accounting rule applies. If this transaction is deemed to be a sale of the old shares and a purchase of the new ones, then there is a profit to be realized under the international accounting standards used in Europe, and UniCredit is entitled to a profit of €1.3 billion before taxes, just as it said it expected to report.

But if the transaction is just an exchange of shares, then under the international rules the increase in value should be recorded in something called “other comprehensive income” and not be recognized in the profit and loss statement. UniCredit would have a bigger loss than it reported.

In the United States, the Securities and Exchange Commission can, if it wishes, determine the proper accounting in a controversial area and can force a company to restate its books. But there is no comparable body in Europe. Instead, the European Securities and Markets Authority, composed of securities regulators in all European countries, last week held a European Enforcers Coordination Session to discuss the issue. They did not disclose an agreement, and even if they had it would not be binding on the Italian regulator.

As a result, UniCredit said the accounting might change. “We changed our accounts several times this weekend,” said Federico Ghizzoni, the UniCredit chief executive, as he explained the situation on Tuesday, “and according to the most recent guidance we’ve received from regulators, this was the best solution.”

It is that kind of indecision, and possibly conflicting interpretations of rules from country to country, that has been cited in the United States by opponents of international accounting standards. The S.E.C. has said that it wants to see evidence of consistent application of rules before it allows American companies to use the standards.

Another accounting issue that has ignited controversy is whether companies should be required to change accounting firms periodically, perhaps every seven or 10 years. Proponents say that audit quality would improve if a second set of eyes looked at the books — and if auditors knew that such a review was going to happen. Opponents say it would raise costs while accomplishing nothing.

An unintended consequence of the current process appears to be something close to providing a second set of eyes. As part of the asset quality review, national regulators have hired accounting firms to review loans and other assets at banks. A bank’s auditor cannot receive that assignment, so this year at least two auditing firms will be looking at each bank’s books.

An audit is not the same thing as the E.C.B. review, having nothing like a stress test. But because both the audits being done now and the E.C.B. reviews are to be based on year-end 2013 numbers, it will be easy to determine whether bank audit clients of particular firms are more likely than others to be forced by the E.C.B. to raise additional capital.

Conceivably, that could cause auditors to be more conservative this year than they have been in previous years. Add that pressure to the general worry about the E.C.B. reviews, and the result may be a lot of red ink in bank financial statements that are released in the next month.