The euro sculpture is seen outside the headquarters of the European Central Bank in Frankfurt
© Kai Pfaffenbach / Reuters
The euro sculpture is seen outside the headquarters of the European Central Bank (ECB) in Frankfurt, November 5, 2013. REUTERS/Kai Pfaffenbach
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updated 1/27/2014 10:58:35 AM ET 2014-01-27T15:58:35

LONDON (Reuters) - The euro zone's grand plan to clean up its banks could falter because the European Central Bank lacks the power to force bankers, constrained by accounting rules, to accept regulators' view of the risks on their books.

The plan aims to give the ECB a 'clean sheet' when it takes over regulation of the euro zone's lenders in November and also to restore investor confidence in the banks which are still valued below their U.S. peers more than five years on from the financial crisis.

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The ECB is assessing if banks in the 18-country euro zone have enough capital to support their business.

Its Asset Quality Review (AQR) of 130 of the euro zone's largest banks' books is already under way ahead of stress tests later in the year. The AQR checks whether banks are currently adequately capitalized, while the stress tests look at whether they can survive a future crisis. Estimates of the banks' total capital shortfall have been as high as $1 trillion.

But accountants, bankers and regulators said the AQR could stumble on legal and accounting issues beyond the scope of the ECB's powers.

Banks have a legal responsibility to value their own assets in accordance with international accounting rules and cannot simply plug the ECB's valuations into their balance sheets.

"The ECB is powerful, but it cannot undo a hundred years of company law," one supervisory source said, speaking on the condition on anonymity since these matters are sensitive.

Banks will still need enough capital to cover the loan-book risks identified by the ECB but the AQR's aim of increasing transparency and investor confidence might fall by the wayside.

A DIFFICULT AREA

The debate is already being played out in Ireland, where Bank of Ireland said it disagreed with some of the values produced by its central bank's Balance Sheet Assessment exercise in late 2013. In Slovenia, a senior bank executive said his bank would not change its end-2014 balance sheets to reflect the findings of an asset review.

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"It's clearly a sensitive area, apart from Spain we haven't really seen banking regulators get involved in the accounting process across Europe," Tony Clifford, partner in financial services at accountancy firm Ernst & Young, said. In pre-crisis Spain, regulators tried to get banks to set aside extra provisions on top those required by accounting rules.

"Banking regulators are likely to have different appetites for pushing these numbers into the accounts," Clifford added.

The accounting rules - International Financial Reporting Standards (IFRS) - which 90 percent of the ECB's banks report under, have a guiding principle that provisions can only be taken for losses actually incurred, and not for expected losses.

Clifford said the main challenge was whether national or European regulators would require banks to make greater provisions than the accounting rules allow.

DETAILS 'UNDER CONSIDERATION'

Another accountancy source said the ECB had indicated it did not want national regulators to push for banks to reflect AQR results in their next financial statements because the concept was too problematic. The ECB declined to comment.

In a letter to European Member of Parliament Sharon Bowles on January 10, ECB president Mario Draghi said the findings from the comprehensive assessment (which includes the AQR) should be carried forward into 2014 results statements. "Precise details in this respect remain under consideration," Draghi added.

A second European supervisor said a capital rule known as Pillar II would allow regulators to force banks to hold enough capital for risky loans even if they are not reflected in banks' accounts.

The ECB and European Banking Authority (EBA) have said the stress tests and AQR results will be released together, but have not said in how much detail.

James Longsdon, co-head of EMEA banks research at ratings agency Fitch, said the AQR had the potential to be hugely illuminating of banks' assets values but would be less helpful if detailed results are not published.

Some regulators may favor greater disclosure if it flatters them or their banks. "National regulators have got their pride on the line," said Bridget Gandy, who co-heads Fitch's EMEA banking team with Longsdon. "None of the regulators are going to want to risk the appearance of having been asleep on the job."

The AQR timeframe - which spans almost a year - could also create turbulence for investors. Several finance experts said banks could be required to let the markets know as soon as they get a sense of how their ECB assessment is going.

Consultants involved in earlier bank stress tests said such information is typically held back from banks for as long as possible, so that they are not put in that position.

"The risk of leaks through the process is also not inconsiderable, given the scale of the exercise and the number of institutions involved," Draghi said in his letter, adding that the ECB will take measures to preserve confidentiality.

(Editing by Jane Merriman)

(c) Copyright Thomson Reuters 2014. Check for restrictions at: http://about.reuters.com/fulllegal.asp

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