In autumn 2014, in order to strengthen the financial and banking system of the European Union, the European Central Bank (ECB) will undertake the functions of а direct supervisor of the largest banks in the Eurozone. In preparation to take on its new role, the ECB initiated Asset Quality Review (AQR) on 128 banking groups in the Eurozone.
In March 2014, ECB launched the final phase of the exercise, which will be followed by an important stress test, whose final results are expected to be published in November. According to representatives of ECB, the results of the current review will require a renewed increase of the regulatory capital as an additional buffer to protect the banks from bankruptcy.
The ECB’s review in Bulgaria
AQR affects 8 out of the 12 largest banks in Bulgaria – subsidiaries or branches of banking groups from the Eurozone. These are UniCredit Bulbank, UBB (NBG), Raiffeisen Bank, Eurobank (EFG), Societe Generale Express, Alpha Bank – Bulgaria, Piraeus Bank Bulgaria and CIBank (KBC). Between now and August, teams of auditors and consultants will be checking average of 1250 credits per banking group. There is still no official information, however, what part thereof falls to the Bulgarian subsidiaries.
As a significant part of the review, the experts will be monitoring whether banks correctly value loans collateral, which is the main uncertainty factor not only in Bulgaria, but also in most European countries. Primarily, the focus will be on mortgages on properties, whose market value has fallen as a result of the financial crisis as this change hasn’t been reflected in its entire amount on the balance sheets of banks.
Shortage of regulatory capital
The ECB’s review could lead to a shortage of regulatory capital through two mechanisms:
Increase of the risk-weighted assets (RWA): For each granted loan, banks need to hold regulatory capital as a percentage of the RWA (12% in Bulgaria, 8% in Europe). According to the regulations of the Bulgarian National Bank (BNB) for mortgage loans, RWA is lower than the exposure itself given the indicator loan-to-value ratio is low enough. I.e., when the market value of the property falls below a certain value, RWA increase, and thus the regulatory capital that banks must maintain.
Additional provisions: Banks’ exposures towards customers are classified into four groups according to their quality – regular loans (up to 30 days past due (dpd)), watch-list loans (31-90 dpd), non-performing (91-180 dpd) and loss (over 180 dpd). According to the regulations of the National Bank of Bulgaria, exposures on a watch-list are provisioned with at least 10%, the non-performing – with at least 50%, and those classified as a loss – with 100%. In case of an unfavorable outcome of the ECB’s review, we may observe a migration of exposures from the more favorable categories to the more unfavorable, which will result in requirements of extra provisions. This additional loss will lead to a reduction of banks’ capital base.
Consequences for the banking sector in Bulgaria
The most likely effect, given an unfavorable outcome of the AQR exercise, is that banks in Bulgaria increase interests and commissions in order to compensate the losses accrued by the additional provisions.
Another possible effect is that banks restrict lending as they will have to hold more regulatory capital. In the current situation, the parent banks from the Eurozone are not able to provide additional capital to their Bulgarian subsidiaries because they are even less liquid and with lower capital adequacy. As a consequence, individuals will be confronted with more severe conditions for a housing loan, for example, as well as business and corporate clients with more difficult access to working capital and funds for new investments.
The probability that, in the coming years, the Bulgarian National Bank (BNB) also apply the new tighter regulatory framework on banks with Bulgarian capital is strengthened by the fact that rating agencies are following their introduction in the country. It cannot be excluded that they reduce the country’s rating in the event that the introduction of the new rules is not executed fast enough. The legal framework in Bulgaria is seen as one of the biggest risks for the banking sector at the moment, along with the low economic growth, weak demand, credit crunch and the significant amount of bad loans.
To avoid a negative impact of tighter regulatory regime on the development of the Bulgarian economy in the next few years, in its report on Bulgaria in January 2014, the International Monetary Fund advises that banks take timely action to clean up their balance sheets. One option is the sale of bad loans and related securities to financial investors, specializing in the purchase of such assets.