The headquarters of the European Central Bank in Frankfurt, Germany. Picture: EPA
The headquarters of the European Central Bank in Frankfurt, Germany. Picture: EPA

Europe’s banks have come a long way since the eurozone crisis. Lenders have halved their piles of non-performing loans from €1-trillion in 2014 to €543bn in the third quarter of 2019. However, markets still doubt lenders’ real strength, as you can see from their depressed price-to-book ratios. The blame falls, in part, on regulators and supervisors.

For years the European Banking Authority (EBA) and the European Central Bank (ECB) have struggled to put together a system of supervisory scorecards that investors deem credible and easy to read. The EBA stress tests, which rely heavily on lenders’ internal models, have been seen as too soft. Meanwhile, shareholders have found it difficult to understand what exactly the ECB expects from their banks.

The EBA and the ECB are taking steps to address these concerns. Last month the EBA floated a proposal that would see the regulator take greater control over the final results of its stress tests. On Tuesday the ECB distributed the results of its “supervisory review and evaluation process,” which will now include exact details of how much capital it expects each bank to hold. These are steps in the right direction, but we really need to go further in Europe. Only more transparent and independent assessments will give people the confidence to invest more in European bank equities.

The EBA discussion paper includes the idea of presenting two sets of results at the end of the next round of stress tests — one from the EBA and one from the bank. This is meant to avoid the current situation, where the crucial calculation on capital depletion is kind of an amalgam of the view of the supervisor and the view of the lender — and is increasingly unsatisfactory for both.

The new approach would have two legs: First, the EBA would take control of the process and present what it was comfortable with; then the bank would be able to present an alternative set of results based on its own assumptions. This greater transparency would, in theory, allow investors to decide which calculation they prefer.

Regrettably, the regulator’s stress test would be based still on the banks’ own internal financial models. This is problematic, since lenders have a clear incentive to tweak them to game the exercise. This so-called “bottom-up” approach is inferior to the “top-down” methodology adopted by the US Federal Reserve. The Fed uses its own models for each bank, giving them little say on these results (US banks publish their own findings too).

Europe’s supervisors believe the Fed approach is not feasible here. The EBA looks after more banks than the Fed, in many more countries. Moreover, its regulators can only build their model using a relatively short time-series because the organisation hasn’t been around long, though this problem should disappear over time.

For now, the proposal would at least give the EBA clear ownership of the result. But one can’t help wondering what the point is of the results the banks distribute for themselves. This second leg risks being superfluous at best, and confusing at worst.

The ECB also needs to make things clearer for bank investors. Many believe it has failed to explain its requests for additional capital — for example in the event of a bank merger. There are also valid questions over how the ECB applies exceptions to its capital requirements for individual banks. Such cases may be justified, but need to be better accounted for to avoid accusations of bias.

The ECB’s decision to publish its so-called “pillar 2” capital requirements (those above and beyond the minimal “pillar 1” requirements) for individual banks will give investors a much better sense of what’s expected from lenders. The list of surcharges should also act as a handy summary of the dangers lurking in each bank. But it will take time for investors to trust the ECB. A tough but stable supervisory regime is needed, in which the goalposts do not keep shifting arbitrarily.

The European banking system is still fragile in places. Profitability in an era of low interest rates is a big worry. In September six banks had capital levels below what the ECB expects from them in 2020.

That's why it is so important to make this stuff as clear as possible. A banking system is only as credible as its watchdogs.

• Giugliano writes columns on European economics for Bloomberg Opinion.

Bloomberg