The European Central Bank (ECB) recently announced the Asset Quality Review (AQR) programme which will commence shortly and is targeted to end by October 2014. The main scope of AQR is to assess the strength (or otherwise) of the significant European banks in order to restore confidence in the private sector and within the banks themselves so as to restart the credit process. Among other concerns, this lack of confidence has been a real concern for the ECB which has been trying to sow the seeds of growth within the eurozone.

AQR will be an interesting programme to monitor on a number of fronts. Among these will be the level of transparency and the stringent measures used throughout the reviews. Keep in mind that recently similar reviews (under the more appropriate heading of ‘stress tests’) were undertaken by a number of national regulators in relation to the banks they are responsible for – the results of such tests were never worrying yet the ECB still feels that private sector confidence has not been restored.

Ergo, the ECB must conduct this review with full transparency and a level of scrutiny which will provide enterprise with the peace of mind required to get the ball rolling.

In addition the ECB has to be prepared to deal, appropriately, with undesirable results. AQR will be a “broad and inclusive” review of Non-Performing Loans (NPLs), restructured loans, on- and off-balance-sheet exposures, sovereign exposures and Level 3 assets (which are typically very illiquid assets). Before expanding further on this point, transparency in the way the ECB treats the various sovereign exposures banks have on their balance sheets will be very important, as it is definitely an area the market will follow very closely. It is important and most welcome that the ECB has captured sovereign assets within its review as otherwise such a program could hardly be defined as “inclusive”. Having said that, the ECB wording does lack detail around the exact treatment of sovereign exposures, hence leaving the door open to all options.

Executing such a review without having thought of a methodology to address the pressing issues could be catastrophic for the banking system and indeed possibly even have a global ripple effect

Going back to the previous point of addressing the issues. Possibly Mario Draghi’s thinking would have started from this end. Executing such a review without having thought of a methodology to address the pressing issues could be catastrophic for the banking system and indeed possibly even have a global ripple effect. It is important to note that this review will be based on the 2013 year-end balance sheets. The banks being reviewed have already been informed and therefore they will be pressing full steam ahead to get their act together (from a balance sheet point of view). In fact more recently, this precise exercise has also been linked to the current EUR/USD rate. EMU-based banks are preparing for the AQR and ahead of this event, equity-weak banks have a high incentive to reduce the asset side of the balance sheet, using proceeds to add to equity positions. Evidence suggests that banks are currently carrying a foreign-denominated asset position which is not matched by an equivalent foreign-denominated liability position. Given the scope of the AQR exercise, such positions are likely to be the first ones to be unwound in order to reduce the capital requirement within the balance sheet. This process could benefit the euro as a result of the repatriation pressure. As time passes, the market will be curious to see whether their hunch was correct.

There is almost a sense of needing to find fault (I would equate it to going to your personal doctor because you are feeling unwell, and being told you are fine – whereas you want to know what’s wrong).

The market will be surprised if no bank needs to be at least repaired (it will be shocked if a bank needs a complete overhaul). Mario Draghi will be aware of this and hence the process must be transparent in order for AQR to achieve the ultimate objective. Well executed, AQR has the potential to help recapitalise banks, restore confidence and over time ease the flow of credit to profitable businesses.

This article is the objective and independent opinion of the author. The information contained in the article is based on public information.

Curmi and Partners Ltd is a member of the Malta Stock Exchange, and is licensed by the MFSA to conduct investment services business.

Karl Micallef is an executive director at Curmi and Partners Ltd.

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