Regulation: Banks set for real estate purge to pass ECB’s health check

Asset and loan sales likely ahead of stress test for European lenders’ books, reports Alex Catalano

Opportunity funds are gearing up for a big flow of European real estate assets and loans coming their way. They think that the European Central Bank’s ‘health check’ of Eurozone banks will force lenders to disgorge large chunks of the real estate that they are still holding.

The ECB is putting 128 Eurozone banks through a financial MRI to see how strong they are. Although Europe’s banks have been recapitalising, raising equity, moving toxic loans off their balance sheets and restructuring their businesses, the ECB wants “clarity”.

So it is undertaking a detailed examination of their holdings, called the Asset Quality Review (AQR), and will run new stress tests to see if banks meet the 13% regulatory capital reserves required under the Basel III accord. This will be the first time that Eurozone banks will be tested using a standardised methodology. Previous stress tests used locally approved data.

Spurring a deleveraging exercise

Kennedy Wilson Europe Real Estate, which recently raised €1.1bn via its initial public offering, thinks the ECB’s move will spur banks “to move newly-classed non-performing loans off of their books to free up capital and hence start their deleveraging exercise”. Ellen Brunsberg, GE Capital Real Estate’s UK managing director, also thinks “there’s going to be a lot more sales and divestments as regulatory pressure changes”.

The AQR is a massive exercise that involves checking 58% of the Eurozone’s risk-weighted bank assets, worth some €3.7trn. In 17 countries, teams of national regulators, helped by independent experts, are going into the banks.

Those chosen for evaluation are the ones judged to be systemically important and include some of Europe’s big real estate players: Aareal, Deutsche Bank, Santander, BNP Paribas, UniCredit and ING. “The evaluation of real estate loans will be an important part of the AQR,” says Stephen Smith, who leads KPMG’s task force on the AQR. “It is difficult to imagine that it won’t have implications for the real estate market.”

Indeed, some banks have started a clear- out in anticipation of the AQR: in March, UniCredit shocked the market by announcing that it was setting aside an additional €7.2bn to cover bad loans in its Q4 results.

The bank said “revised guidelines on real estate collateral haircuts, based on updated appraisals and forced sale criteria in Italy” were partly to blame. It will sell €55bn of non- core and non-performing loans over the next five years. Others are expected to follow suit.

The AQR has national regulators’ teams examining, on a granular level, banks’ exposures to borrowers: sovereign entities, institutions, corporations and individuals. It is their riskiest portfolios that the banks must open up – those with “biggest potential for misstatement”, as ECB officials described them. Banks must also offer up at least 50% of their risk-weighted assets for examination.

Loan-by-loan inspection

Moreover, it is a loan-file-by-loan-file, asset-by-asset inspection that will establish whether banks have been correctly valuing and classifying these assets – and whether any provisions they have made for bad loans have been set at an appropriate level.

“From a real estate perspective, there are two important points,” says Smith. “First is the crackdown on ‘extend and pretend’ forbearance to borrowers, and the second is the requirement for independent valuations to be no older than 1 January 2013 for all collateral relevant to assessing impairments.”

The ECB is using the European Banking Authority’s agreed definition of a non- performing loan: any material debt exposure  90 days past due, even if it has not been recognised as defaulted or impaired.

Banks are providing tapes with data about the loans in their portfolios and the teams will review a sample of these credit files (see below).

“The tapes have about 70 items of data per loan and the banks are required to fill out a template supplying documentation on the credit files chosen for review,” says Smith. “A major ECB agenda is to ensure consistency across the banking system.”

This exercise should flush out any nasties still hiding in banks’ balance sheets; the transparency and consistency will, the ECB hopes, give confidence in their strength. The results of the AQR will be used to run new stress tests on banks’ balance sheets.

If the stress tests reveal problems, the ECB is threatening “a range of follow-up actions, possibly including requirements for changes in a bank’s provisions and capital”.

According to Richard Thompson, chair  of PwC’s European portfolio advisory group: “The key message is that the stress test will lead to further bank restructuring.

It will provide a big opportunity for those funds and other investors buying non-performing loans.” As UniCredit’s actions show, coming clean before the stress test may be the wisest course of action.

The exercise will be completed by November, when the ECB takes responsibility for supervising Eurozone banks. Our advice is that the people who will do best will be those who take a realistic view and take swift action,” says Smith. “If you wait until 2015 you might be selling into a crowded market.”

Prudential checks provide a test for UK banks’ balance sheets

UK banks do not fall under the European Central Bank’s Asset Quality Review, but that does not mean their assets are not under similar scrutiny.

The regulator for the Bank of England is in the midst of its second health check on the UK’s eight top lenders: HSBC, Lloyds, Barclays, Standard Chartered, Nationwide, RBS, Santander and The Cooperative Bank. The stress test will become an annual exercise.

Like the ECB’s, the UK regulator’s asset quality review is what one senior real estate lender at a UK bank calls “a deep dive” into UK banks’ asset quality and risks, focusing on factors such as how much cashflow is exposed to particular customers and the loss ratios on their core books.

In a perfect world, regulators would like to see loss ratios as low as 0.1-0.2%, in stark contrast to the dark days following the collapse of Lehman Brothers, when there were examples in real estate books of loss ratios being many times higher – above 30% in some cases.

Bank supervision at the level of individual companies has been the responsibility of the Prudential Regulation Authority since last April. The PRA works closely with the Bank of England’s head of financial stability.

It sounds like a testing time for the banks, but, says the lender, “what the regulator is trying to do is stop another 2007 meltdown. So there are no credit standard shifts going on. We are still well  within our cashflow servicing caps that all banks want now. “No one wants to make the first bad loans and there are absolutely no prizes for getting something wrong with new business.”

Property loans probe will highlight lenders’ true values

The European Central Bank wants to know whether the real estate valuations banks have used for the assets on their balance sheets, or the provisions they have made, are “appropriate”.

There is still a widespread suspicion that some banks, in some countries, are being economical with the truth: that they are using out-of-date property valuations; pretending that loans are performing when they are not; putting too much hope value on assets; or minimising the write-offs for bad loans.

So the ECB has set out its guidelines in a 287-page manual, with real estate and collateral valuation taking up 17 of these. The manual says that values should be updated  “either by having collateral revalued by a third-party expert, or by updating a recent independent, external market valuation”.

The ECB’s guidance on this is clear: if  an independent, third-party appraisal of market value has been carried out since January 2013, the asset does not need to be re-appraised; the value can be updated using an appropriate index.

However, a local valuation approach standard to a specific country can be  used instead of market value if it is more conservative. To avoid confusion, the ECB explicitly says mortgage lending value can only be used for real estate if it is explicitly less than market value in all cases.

The valuation must accord with the European Valuation Standard “Blue Book” or an equivalent international one, such as the RICS guidelines. The valuations are expected to be desk-based, though drive-by inspections might be necessary in some cases, more as a “plausibility check”.

If the re-appraisals are not more than 5% off the indexed December 2013 values, the latter can be used for further analysis. Typically, the ECB says, “in exercises of this sort, the appraisal can be handled more efficiently by a specialist firm”. National regulators will provide the teams with a  list of such firms to be used “for process efficiency”.

However, so far the AQR is not providing a big workflow for specialist real estate firms. Instead, the “big four” accountancy firms appear to be getting most of the contracts, as the AQR involves all the banks’ assets, not just real estate. And it looks like they will be using their in-house real estate teams, bringing in outside real estate specialists as needed on a subcontracted basis.

The revaluation exercise for real estate has been pencilled in to start in mid-March and be finished by early June.