* ECB says to finish portfolio selection in mid-February
* AQR methodology will be finished in coming weeks
* ECB to apply EBA parameters for stress test
* Timeframe to boost capital buffers to depend on scenarios
By Eva Taylor and Jonathan Gould
FRANKFURT, Feb 3 The European Central Bank kept
the euro zone's top lenders on tenterhooks as it promised to
reveal the strategy for its unprecedented review of bank balance
sheets by the end of March, giving only scant detail on Monday.
The ECB's asset quality review, or AQR, is part of a broader
examination that also includes a stress test to see how banks
hold up under shock scenarios, to avoid nasty surprises once it
starts supervising them from November.
The exercise aims to encourage banks to recognise losses on
loans or investments that have soured over time, allowing them
to regain investors' trust and free up capacity to grant new
loans to help along the euro zone's fragile economic recovery.
By holding back details of the AQR, the ECB will keep banks
on their toes.
"Firms' auditors don't send around the audit manuals to
clients," said Stephen Smith, head of KPMG's AQR Task Force.
"There's a danger that people might start to game you (if they
know the details too far in advance)."
Confidence in the sector remains fragile despite more than 1
trillion euros ($1.4 trillion) of state support since the global
financial crisis and the euro zone's debt problems underlined
the risky relationship between over-indebted governments and the
banks who buy many of their sovereign bonds.
The European Union's latest health checks are intended to
settle any lingering doubts over its finances.
On Friday, the European Banking Authority (EBA) set out
parameters for the stress tests and the ECB said it would apply
them as well, aiming to give banks the stress test scenarios by
the end of April.
Euro zone banks will get some time to meet the capital
shortfalls highlighted by the scenarios, but the gaps from the
baseline scenario in which banks must have a core capital ratio
above 8 percent need to be addressed right away.
"A shortfall relative to the baseline scenario will require
that capital be raised in the nearer term, whereas a shortfall
arising from the adverse scenario may only require capital to be
raised over a more extended period, on the basis of an agreed
capital plan," the ECB said in a statement.
KPMG's Smith said a marked difference to previous rounds of
stress tests was the ECB's clear intent to carefully examine
banks' trading assets as well as their loan assets. "It confirms
that the AQR will be looking at the darkest recesses of bank
balance sheets," he added.
On the key question of valuing government bonds, the ECB
said sovereign debt held in the available-for-sale and
held-for-trading portfolios would be marked-to-market.
The ECB also said capital instruments that can automatically
be converted into common equity tier 1 capital (CET1) "may be
eligible for use to address a capital shortfall arising from the
adverse stress test scenario, as long as the conversion trigger
is set at 5.5 percent or above."
This could help the sector.
"We believe that this provision will significantly reduce
the need for upfront recapitalisations across Europe, and
consequently should be positive for both bank equity and
subordinated debt in 2014," said Ciaran Callaghan, banks
analysts with Dublin-based Merrion Capital.
The AQR and the stress tests will feed into each other and
their timings will overlap somewhat, but the overall result
-spelling out the size of any capital shortfall - will be
published only in October.
Analysts have estimated the tests will show the banks need
up to 100 billion euros ($135 billion) of fresh capital.
Over the past couple of months, the ECB has collected vast
streams of data from the 128 banks that are taking part in the
exercise and some lenders have to deliver extensive detail on
their trading books and risk models by Feb. 7.
National supervisors have also identified particularly risky
portfolios they would like included in the in-depth review,
which the ECB will review and approve by mid-February.
The actual review of assets, collateral and provisioning in
the selected portfolios will start in March.