European Central Bank to press banks to change models they use to predict losses, examine views on asset valuation if ECB is unhappy with banks' risk assessment, signaling aggressive stance in review of bloc's lenders

Cindy Allen

FRANKFURT , March 11, 2014 (Thomson Reuters Corp.) – The European Central Bank will press banks to change the models they use to predict losses and take account of its views on asset valuation if the ECB is unhappy with their risk assessment, signaling an aggressive stance in its review of the bloc's lenders.

The ECB is putting the euro zone's 128 largest banks through a painstaking review of their loan books before becoming their supervisor in November in a bid to force them to come clean on hidden losses and restore investors' trust in the sector.

Between now and August, teams of national supervisors and auditors will check on average 1,250 credit files per bank - significantly more for larger banks - against common guidelines that the ECB published on Tuesday. The total exercise will cover 58 percent of banks' assets as weighted by risk.

A test to see how banks would hold up under certain shock scenarios will follow over the summer and all results will be released in October. Estimates of banks' capital shortfall range from 280 billion euros to as much as 770 billion.

The scope of the tests is unprecedented. Euro zone banks have never been measured against common thresholds, such as a single definition of when loans become impaired and many have never had their books interrogated in such detail.

Once the results are known, the ECB will push banks to reflect some of the findings in their 2014 accounts.

"Banks may be expected to correct specific provisions for collectively impaired credit facilities, where the bank's collective provisioning model is considered as missing crucial aspects required in accounting rules," the ECB document said.

"In this case, banks would be expected to correct internal models and policies."

Banks will only be expected to change their 2013 accounts in the unlikely event that the review highlights issues that should lead to restatement according to local law, it said.

Banks had been asked to adapt their asset valuations after reviews late 2012 in Slovenia and Ireland, but with limited success.

The ECB's guidelines also set out different scenarios when loans should be classified as impaired. For example when a debtor has requested emergency funding from a bank, or if a company that has taken a loan gets into financial difficulty and experiences a material decrease in turnover or the loss of a major customer.

ARTWORK, SHIPS AND AIRCRAFTS

As part of the exercise, the teams will also check whether collateral, for example in the form of real estate, aircraft, ships or artwork is correctly valued, with help from external experts or by updating recent independent market valuations.

"Generally, the majority of collateral will be revalued for all debtors selected in the sampling that do not have a third-party valuation less than one year old," the document said.

Beyond loans, 'level 3 assets' - a broad group of assets that are difficult to value - will also be assessed.

These include derivatives and assets such as real estate holdings banks have acquired through foreclosures, their participation in private equity deals and special investment vehicles.

"It is expected that, in most cases, fewer than ten derivative pricing models will be reviewed for each bank included in the trading book review, depending on the size of the bank's exposure to level 3 derivatives," the manual said.

Some banks included in the trading book review will have no relevant level 3 derivative pricing models to review, it added. ($1 = 0.7205 Euros)

(Reporting by Eva Taylor and Laura Noonan; Editing by Erica Billingham)

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