European Central Bank: Credibility test

It was an extraordinarily brutal attack for the normally dry world of financial regulation. In June 2011 Jochen Sanio, then head of BaFin, the German financial watchdog, told his regulatory brethren at the European Banking Authority they lacked legitimacy and risked falling into "disrepute".

The sideswipe was prompted by the EBA's "stress tests" of EU banks, which threatened to expose big capital holes in lenders' balance sheets just as tensions in the eurozone were reaching their zenith. Supervisors such as Mr Sanio were anxious to temper the severity of the EBA exercise so it did not heavily penalise the banks under their watch.

They broadly got their way. The tests managed by the EBA were later derided as excessively lax not only by analysts and investors but also by Angela Merkel, the German chancellor. She attacked national regulators for softening the parameters out of "misguided national pride".

Franco-Belgian lender Dexia was rubber-stamped as financially robust, only to need a third rescue. So was Laiki, a Cypriot bank that was later sunk by its heavy Greek bond holdings. Bankia, the lender whose downfall later helped force Spain into a bailout, sailed through unscathed.

Now euroland claims to have learnt the lessons of what one top EU official calls its "howling mistake" - its failure to fix its banks.

Having botched banking turnround exercises in 2009, 2010 and 2011, the bloc is embarking on what participants say will be the most complex and far-reaching set of bank health checks in history as part of plans to glue the single currency together through a banking union.

The stakes are extraordinarily high. With private sector lending spiralling downwards, large parts of the region's economy in recession and periphery countries facing far harsher lending conditions than the core, the eurozone's financial markets remain badly fragmented.

Policy makers are gambling that by turning the European Central Bank into a single supervisor at the heart of a revived banking sector they will be able to tear down the regulatory and capital barriers that have sprouted across the single market.

Jorg Asmussen, an ECB executive board member, called it Europe's "last chance" to clean up the banks and revive lending. But there is more at stake than that. The exercise will be a test of credibility for the ECB; Nicolas Veron, a banks expert at the Bruegel think-tank, says it is a "make or break" moment for the institution.

Yet the exercise will be only as good as the measures to deal with the exposed capital hole. How will it deal with banks that fail? When the results emerge, Europe will lack a single system for winding up lenders and common resolution funds, or a central bad bank to house toxic assets. Frankfurt will have to rely on a patchwork of national authorities, Brussels' rules to police bank rescues and national backstops if junior investors cannot shoulder the costs. "The ECB is aware of the reputational risks but it's not all under their control," says one senior central banker.

Complicating matters further, the ECB has no institutional experience with bank supervision, which until the banking union plans were hatched remained a jealously guarded national prerogative. Investors and bank chiefs complain they are still unclear about important elements of its 12-month "comprehensive assessment" of the banks - with the confusion reflected in wildly diverging market estimates of the capital holes the health check is likely to unearth.

The ECB is forging ahead regardless. In November the central bank called an extraordinary round of meetings with the top banking CEOs in Europe as it laid the groundwork for its comprehensive assessment.

Executives from the top 130 financial institutions were summoned on three separate dates in groups of about 40 to meetings at its central Frankfurt tower. After lunch the banking bosses received in-depth presentations from ECB chiefs including Mario Draghi, its president.

Mr Draghi is aiming to deliver what one bank chief calls the "knockout punch" that finally kills the malaise afflicting its banks and establishes his own institution's credibility as a supervisor in one fell swoop. The assessment will entail a snapshot of the risks being run by the banks, followed by an in-depth asset quality review and stress test gauging banks' resilience to a range of shocks.

Banks have already been sent a questionnaire that will direct the in-depth examination of their portfolios of loans and assets. Responding to this preliminary inquiry alone will, in the words of another senior banker, be an "extremely challenging effort" as lenders gather thousands of cells of data from their sprawling networks.

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The ECB had only a small internal staff and a group of young secondees from national authorities - jokingly labelled its "special forces" - to kick-start the exercise. It is drawing heavily on manpower from management consultant Oliver Wyman as well as from national authorities.

Market expectations of the outcome of the comprehensive assessment vary sharply. A survey of investors by Goldman Sachs suggested 11 banks would fail the test and €75bn of capital would need to be raised, with Italian, German and Spanish banks potentially in the line of fire. A separate poll by Morgan Stanley suggested a total capital raising of €40bn.

This is in part because bankers still have big questions about the process - not least over the sections of their balance sheets that will be probed and the parameters of the stress test that the ECB is running with the EBA. The latter prong of the assessment attempts to offer a view of the banks' resilience but the detailed stresses the banks will have to withstand are still being discussed.

Italy is seen by many officials as particularly vulnerable. While Spain, Ireland, Portugal and Greece have been through probes as part of their crisis recovery programmes, Italy's banks have yet to be subject to external scrutiny.

At a briefing at the Italian embassy in London last month, officials from its central bank suggested their banking sector has been unfairly singled out. They pointed out that Italy observes a tougher definition of non-performing loans than other big European countries. This should mean Italy would be relatively unscathed by the process of harmonising the definitions of a bad loan.

What makes its banks particularly weak, however, is Italy's continued economic contraction. Gross domestic product is forecast by the European Commission to shrink by 1.8 per cent this year before expanding just 0.7 per cent in 2014, which threatens to drive up loan losses. Italian banks have large holdings of government bonds, which could leave them exposed depending on how the stress tests are designed. Should the results be worse than expected, Italy may be hard pressed to borrow money for a big recapitalisation.

Mr Veron says he has been impressed by the ECB's handling of the exercise and the co-operation it has received from national regulators - which are far less likely to lock horns with the eurozone's powerful central bank than they were with the welterweight EBA. Still, he warns that 2014 could have higher levels of market volatility than 2013 in the lead-up to the results.

With results of the health check not expected until September, and plans for centralised bank resolution still in flux, people familiar with the process argue that investor confidence in banks could ebb over the coming months if information leaks out bit-by-bit. "It's a very long time to wait for an answer," says one adviser.

This is a concern the ECB is well aware of and there are discussions of quarterly progress updates, with the first likely in late January or early February.

But the protracted period of uncertainty could induce banks to be even more conservative about lending than they are already, with private sector lending down a record-equalling 2.1 per cent in October from a year earlier.

Lorenzo Bini Smaghi, a former ECB policy maker, says some banks are already engaged in a "race to the top" as they attempt to improve their 2013 balance sheets. This risks creating a credit crunch, he argues.

Eurozone plans to "bail in" bank creditors if public money is needed could only heighten the risk of market panic, he argues, calling this "typical European masochism".

He contrasts America's handling of stress tests back in 2009, where public money was readily available and quantified right at the start of the process. "Here [in Europe], without the fiscal backstop at the start, it creates an incentive to deleverage, and then we live with this uncertainty for a year," he says.

Yet this Brussels requirement to impose losses on junior creditors in troubled banks - as practised in Spain - is perhaps the eurozone's main defensive buffer should private investors balk at filling the capital hole. Some senior officials think it may be enough to spare taxpayers. Mr Draghi has warned that overzealous bail-in could "destroy" confidence.

It speaks to the importance Frankfurt places on the public safety net behind this process. Earlier this year, Mr Draghi drily admitted the eurozone did not have the "magic powers" America displayed in its 2009 stress test, when the capital needs of the banks turned out to be exactly equal to the public money available to support them.

He has been pushing relentlessly for eurozone ministers to deliver certainty on the backstops that are meant to underpin the exercise.

Ministers have promised to make "necessary arrangements" at the national level - but no specific amounts have been pledged. Eurozone loans would be available to countries facing difficulties - for those willing to swallow the tough conditions attached. Eurozone funds could be put directly into a bank but Germany will not agree the rules. In sum, the eurozone has primarily clarified its existing backstops; there is nothing new for the asset quality review.

The ECB is putting a brave face on the outcome of the long backstop debate. However, its chiefs know that they cannot afford another botched stress test.

To fumble this attempt to turn Europe's banking malaise round would not only undermine the eurozone's boldest attempt to get to grips with the euro's woes.

It would also strike at the core of the reputation of one of the few European institutions to survive the crisis with its stature undiminished and its powers enhanced.

The woman building a eurozone regulator

The task of building up the ECB's new supervisory function will fall to Daniele Nouy, secretary-general of France's Prudential Supervision and Resolution Authority, writes Sam Fleming.

Ms Nouy, whose appointment was approved by the European parliament yesterday but still needs endorsement from national capitals, is well known among regulators, having joined the Bank of France in 1974.

She has long been considered the top contender to lead the single supervisor in light of her work steering her country's banks through the financial crisis and her international experience, which includes a five-year stint as secretary-general of the Basel Committee on Banking Supervision.

The ECB has also been anxious to promote women, especially following protests over the appointment of Yves Mersche of Luxembourg to the ECB's all-male executive board.

One person at another regulator who has worked closely with Ms Nouy, 63, describes her as a "hard negotiator but a fair one".

Her immediate task will be to manage the hiring of close to 800 supervisors, as well as support staff. It will not be easy. Interviews for the top 10 posts are under way, and while the salaries - ranging from €165,000 to €245,000 - are generous, people familiar with the process say it is a struggle to recruit from the private sector, leaving the ECB heavily reliant on candidates from the national authorities.

Once the top officials have been recruited, mid-ranking officials will be brought in, with the ECB aiming to have supervisory teams overseeing individual banks in place by the spring.

David Green, a former senior official at the Bank of England, says Ms Nouy will take on broad responsibilities, overseeing complex regulatory decisions and managing delicate relations with national supervisors.

Her role will be to take charge of a supervisory board that assembles representatives from national regulators, four from the ECB and a vice-chair from the ECB's executive board.

Ms Nouy will also have to maintain close ties with the authorities overseeing the City of London, where eurozone banks have extensive operations. "She is very well known in London, which will be crucial because of the dialogue with the Bank of England and Financial Conduct Authority," Mr Green adds.

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