The EBA banks’ balance sheets assessment and the standardisation problem

About two weeks ago, the European Banking Authority announced their standard definitions of impaired loans (i.e. non-performing loans) and other asset quality standards, which aim at harmonising the various definitions in place throughout Europe for their upcoming asset quality review. Today, I won’t even be mentioning the odd fact to see a regulator getting in a bank for a few days and basically telling the bank that it knows its loan book better than the bankers themselves. No, today I will only speak about the harmonisation issue.

Banks have different ways of classifying past-due loans, impaired loans, loans in forbearance and so on, not only in between countries but also within countries. For instance, in the UK, I know some banks that will classify all loans in forbearance as impaired, artificially pushing up their headline bad loans ratio, while others do not, looking better as a result to the untrained eye. Most British banks will automatically classify loans 90 days and more in arrears as impaired, whereas most French banks will only apply the impaired definition when loans are 180 days and more in arrears.

So a standardisation seems to be a good thing as data becomes comparable. Well, it is, and it isn’t. To be fair, standardisation within a country is probably a good thing, although shareholders, investors and auditors – rather than regulators – should force management to report financial data the way they deem necessary. However, it makes a lot less sense on an international basis. Why? Countries have different cultural backgrounds and legal frameworks, meaning that certain financial ratios should not be interpreted the same way from one country to another.

Let’s take a few examples. In the US, people are much more likely than Europeans on average to walk away from their home if they can’t pay off their mortgage. Most Europeans, on the other hand, will consider mortgage repayment as priority number 1. As a result, impaired mortgage ratios could well end-up higher in the US. But US banks know that and adapt their loan loss reserves in consequence. Within Europe, legal frameworks and judiciary efficiency are also key: UK banks often set aside fewer funds against mortgage losses as the legal system allows them to foreclose and sell homes relatively quickly and with minimal losses. In France on the other hand, the process is much longer with many regulatory and legal hurdles. Consequently, UK-based mortgage banks seem to have lower loan loss reserves compared with some of their continental Europe peers. Does it mean they are riskier? Not really.

Another (abstract) example: in country A, the local culture pushes people to pay off their debt at all costs, whereas in country B, most people, once they stop paying back when they run into short-term trouble, never resume payment. In country A, banks consider it safe to classify a loan as impaired only after 180 days without payment. In country B though, banks know that the loan will never be paid off as soon as it is 30 days past due. Standardisation would make both countries use the same classification. Why not, but it doesn’t bring much: analysts will still have to take into account local variations (just in a different way). However, it might spark an unnecessary panic in country A when figures suddenly look much worse to the untrained public.

This is the issue with harmonising. Some standardisation may be welcome, but most analysts and investors already know the differences in reporting between countries and don’t take headline figures at par value, making the EBA exercise relatively pointless. For the less-well informed individuals, the EBA harmonisation could also bring a false sense of safety: figures look comparable, but in reality, they’re not entirely. In the end, harmonised reporting or not, adjustments always have to be made…

The same apply to most internationally-applied regulations. Basel rules, for example, effectively apply standardised capital and liquidity requirements throughout the world (with some local implementation differences). Banks in higher-risk countries have to comply with the same capital ratios as banks in lower-risk countries, the adjustment being made through risk-weighted assets…which are easily gamed. But analysts know well enough that a 17% regulatory Tier 1 ratio (a key bank capital safety ratio) is actually poor for an African bank, despite looking high by Western standards and way above official requirements.

In the end, standardisation makes particular sense in geographical areas where both culture and legal frameworks present only minor differences, such as the US. Europe is still a pretty fragmented continent, and it doesn’t look like things are going to change overnight. The EBA hasn’t been very clear about the exact implementation of its criteria. Let’s just hope they keep the issues discussed in this post in mind.