The European Central Bank has outlined today how it plans to scrutinise top euro zone lenders before becoming their supervisor in a new role that puts its credibility on the line.
Irish banks to be tested include Bank of Ireland, AIB, Ulster Bank Ireland, Permanent TSB and Merrill Lynch International Bank, which has its headquarters here.
Under the terms of the tests, banks must have core tier 1 capital of 8pc of its loan book, for example.
The ECB wants to unearth potential risks hidden in banks’ balance sheets before banking supervision is centralised under its roof from November 2014 as the first part of a plan for European banking union aimed at preventing financial crises.
That broader plan was drawn up in response to the euro zone debt crisis that undermined economies and financial markets around the world and was made worse by underlying banking weakness in several countries including Ireland and Spain.
The ECB tests should help revive trust in Europe’s battered banking sector by aligning countries’ definitions of bad loans and the quality and risk weighting of certain assets, helping investors compare banks across borders.
The review will be tough so the ECB does not face surprises once it has taken charge and to avoid repeating mistakes of two earlier European-wide stress tests that failed to spot risks that led to the Irish and Spanish banking crises.
However, if the asset quality review is too rigorous it could undermine confidence in the currency bloc and bond yields could rise again, making it harder for the central bank to fulfil its main monetary policy role of keeping prices stable.
“A poorly-managed exercise would undermine the ECB’s credibility as supervisor from day one, with potentially adverse consequences also for its credibility in the field of monetary policy,” said Unicredit’s chief euro zone economist Marco Valli.
Some ECB policymakers feel uncomfortable taking on the extra responsibility and have suggested spinning off bank supervision into a separate institution over the long term. But such a step would require a change of the EU treaty, which might take years.
The ECB plans to run the asset quality review in the first half of next year, followed by stress tests in cooperation with the European Banking Authority that will look at how banks react under certain shock scenarios. All results are due in October.
Despite the progress on the first leg of the banking union, the second stage – how to salvage or wind down banks that run into trouble – is unresolved as politicians discuss how much of the costs should be shouldered by taxpayers.
Many banks may be unable to raise capital on their own and the euro zone crisis showed that often even national governments cannot afford to stage rescues. In addition to Ireland, Spain – the bloc’s fourth biggest economy – had to take international help to tackle its banking problems.
The tests apply to 130 European banks.