* Impairments and 'hard to value' assets key areas
* Loans pitted against auditors' 'challenger models'
* Collateral not valued for over a year must be revalued
By Laura Noonan
DUBLIN, March 10 The European Central Bank's
stance on how bad loans are defined will be one of the biggest
revelations to the euro zone's largest banks when it details on
Tuesday how it will test balance sheets, three sources with
knowledge of the tests told Reuters.
The details will give the 128 banks being tested their most
explicit insight to date on how their books will be examined by
inspectors looking at whether they need billions of euros of
extra capital to strengthen balance sheets. Estimates of the
capital shortfall range from 280 billion euros ($388.13
billion)to as much as 770 billion.
The tests are being carried out to restore investor
confidence in the banks and clean up any problems left over from
the financial crisis before the ECB becomes their supervisor in
As well as the initial review on whether banks' assets are
correctly valued now, banks will also be subjected to a stress
test looking at whether they need more capital to deal with
A document detailing the tests' methodology has been in
circulation amongst national supervisors and consultants for
several weeks. Recipients have signed non-disclosure agreements
and face penalties for any breaches.
"It will terrify them, even though they've got a reasonable
idea of what's coming," one source with knowledge of the
guidelines told Reuters, pointing to the very prescriptive
approach laid out over nearly 300 pages.
The ECB declined to comment.
The three sources said the most closely-watched areas in
Tuesday's announcement would be the ECB's view of when loans
become impaired, and the way 'hard to value assets' are treated.
For loan losses, the guidelines include a simple rule that
any loan more than 90 days overdue is non-performing and a more
complex one that sets out the other triggers that suggest full
repayment is unlikely, two of the sources said.
A third source said that while the ECB's decision on
impairment triggers was "reasonable" some banks would still fall
short of it since not all banks would use all the triggers on
the ECB's list of definitions of indicators for impairment.
Triggers can include things like evidence that a corporate
borrower is in distress and evidence that the value of the
collateral underpinning a loan has fallen. "Triggers can be
subjective," the second source said.
If a loan's status is changed from performing to
non-performing, it would have a higher probability of default,
some thing that would force a bank to set aside more capital to
provide for higher likely losses.
Banks' estimates on loan losses will be pitted against
'challenger models' created by external auditors - carrying out
the tests on behalf of supervisors - an approach first tried in
Ireland's balance sheet assessment in late 2013, two of the
Previous rounds of bank tests have tested the models in use
by the banks rather than creating brand new ones.
The rules also require that new valuations must be done for
any collateral that had not been valued within a year of January
2014, two of the sources said.
Beyond loans, the ECB's treatment of 'Level 3 assets', a
broad group of assets that are difficult to value, will also be
closely watched. Those Level 3 assets include derivatives and
also include assets such as real estate holdings banks have
acquired through foreclosures, their participations in private
equity deals and special investment vehicles.
The ECB has taken care to prevent any leaks. Recipients of
details of the review face fines of 100,000 euros for leaks and
copies have been water-marked with the name of its owner, the