The ECB’s comprehensive assessment of the EU’s banks will boost the legal market, write Jon Kibbe and Julia Lu.

On October 26, the European Central Bank (ECB) released the results of its ‘comprehensive assessment’ of the financial health of 130 banks in the EU. Of those 130, 25 banks ‘failed’ the test. Within that group, 12 banks have already raised capital to bring their capital ratios into compliance, and 13 banks will be required to raise an aggregate €6.1bn in the next six to nine months.

In the grand scheme of things, these numbers do not appear insurmountable. The collective sigh of relief from the European markets, and the banking sector in particular, was audible.

However, the knock-on effects of the comprehensive assessment will extend far beyond the pass/fail scores that grabbed the headlines. The results provide unprecedented transparency to the balance sheet and asset positions of the banks. Bank regulators, rating agencies, bank owners and bank creditors will likely prompt the banks to make specific improvements to their balance sheets, including reduction of previously opaque risk exposures.

European distressed debt investors anticipate a key component of the banks’ capital plans to improve key capital ratios to be asset sales designed to reduce risk-weighted asset values, including sales of non-performing loan portfolios. Similarly, disposal of loans collateralised by assets subject to a ‘large haircut’ [inability to recover the full amount owed] or loans requiring high loan-loss provisions could reduce the cost of holding assets, improve earnings and increase Common Equity Tier 1 (CET1) capital.

The effort to engineer improvement of bank balance sheets is projected to generate market activity of genuine interest to distressed investors, and that in turn will have a substantial impact on the legal market. Some of the potential consequences are briefly summarised below.

1. Banks and their counsel will need to consistently apply the non-performing exposure classification to their assets, and deal with the €136bn of increased non-performing exposure as a result of the comprehensive assessment across all asset segments, with large corporates, shipping and project finance segments seeing the highest percentage increases. As more assets become classified as non-performing, banks will face increased pressure to dispose of them.

2. Banks will need to hold additional provisions for impaired financial assets in the aggregate amount of €43bn. Sector by sector, the increased provisioning is most apparent in shipping loans (in relative terms, or basis points of credit risk-weighted asset), and in large SMEs, large corporates and real estate-related assets (in absolute terms, or euros). This additional provisioning will increase the cost of holding impaired assets in these sectors, and as a result many banks will be more eager to sell them in the secondary market as bespoke single asset sales or themed portfolio sales transactions.

3. While the ECB applied a buffer on present value of projected cashflows in calculating the provisions for shipping assets held by the in-scope German banks, it was careful to note that the buffer was only for purposes of the comprehensive assessment, and would not be required on a going-forward basis. This should afford some relief to these German banks, and may mean that shipping loans, although increasingly expensive for European banks to carry on their balance sheets, may not present as significant a problem as the figures in the comprehensive assessment suggest (a 25%, or €1.5bn, increase of aggregate provisioning), at least not for the German banks.

4. Banks will need to take higher collateral ‘haircut’ levels as agreed with the ECB. The reduction in collateral value most severely affected commercial real estate properties and land, with the value of those located in Mediterranean and central Europe being reduced the most in relative and absolute terms. Loans backed by those types of properties are likely candidates for sale because they are now even more costly to keep on the balance sheet.  

5. A number of banks have sustained large adjustments to their asset carrying values (for example, around €1bn per bank) relative to their risk-weighted assets (for example, €25-75bn per bank). These banks have either failed or scored low on the CET1 ratio tests, and will have a heightened need to devise and execute plans to reshape their balance sheets with a more comfortable capital buffer. Such a plan could involve, where practical, a combination of efforts to raise fresh common equity capital and to sell assets, the carrying value of which was subject to material downward adjustment.

6. Banks that have an immediate need to raise capital as a result of the comprehensive assessment are now possible targets for takeover by stronger, better capitalised banks. This is particularly true for banks that cannot easily raise capital in their local market (for example, some Italian co-operative banks). The transparency to banks’ asset quality provided by the ECB exercise provides a roadmap for potential merger and acquisition activity, and will probably help in the due diligence and structuring of these types of transactions. Media reports of takeover bids have already trickled in following the comprehensive assessment.

These developments have been interpreted in the market as a tremendous opportunity for distressed investors, and any resulting large-scale distressed asset sale will likely improve the overall health of the distressed trading market. After an extended period of inactivity, investors in European distressed debt now have a reliable way to assess sellers and predict large-scale asset dispositions.  

Beyond an increase in distressed investment activities (including non-performing loan portfolio sales, shipping asset or real estate asset dispositions), there is also likely to be focused capital markets activities and consolidation through mergers and acquisitions. These transactions will need advice and guidance from capital markets, M&A and banking lawyers specialising in the relevant disciplines and located in the relevant jurisdictions.

Lawyers will add value by establishing the legal and economic rights and expectations of the banks and their stakeholders, including shareholders, creditors, customers (borrowers and depositors) and employees, all in accordance with the mandates of the national and European regulators, as the banks respond to the comprehensive assessment.

Jon Kibbe and Julia Lu are partners at Richards Kibbe & Orbe