The European Central Bank will consider the impact of future lawsuits and fines in its review of whether the Euro zone's 131 most important lenders have enough capital to withstand another recession.
The treatment of legal costs was outlined in a 72-page document detailing the quality assurance program the ECB will use to assess the reams of data it has gathered about banks' portfolios, as well as the way this information will be fed into predictions of banks' future losses.
The highly-technical document was published on Friday as part of the ECB's effort to ensure the tests are transparent and credible, crucial aspects if the ECB is to achieve its goal of removing investors' lingering doubts about Euro zone banks before it becomes their supervisor on Nov. 4.
We are dedicating considerable time and effort to making this process rigorous, said Vitor Constancio, vice president of the ECB, adding that this distinguished its exercises from previous reviews by the European Banking Authority (EBA), which were widely discredited.
Euro zone banks have faced a raft of fines for litigation since the ECB planned its review last year, most notably BNP Paribas' 9 billion June penalty to settle sanctions violations.
”Where the PP&A (processes, policies and accounting) review has highlighted any issues in relation to legal costs, the bank should have already been informed and instructed to take this into account in the projections of the stress test,” the ECB said in its stress tests manual.
This implies that banks at risk of litigation must make deductions from their future profits as they estimate how much cash they could burn over a three-year horizon.
Banks that don't make appropriate provision for this, or any other aspect of how their books would fare in a downturn, will have to amend their numbers if the ECB uncovers the shortcomings as part of its quality assurance process, the ECB said.
This process will look at whether future losses have been correctly calculated, and will compare loss rates across banks in different countries.
Banks whose loss expectations are found to be in line with the ECB's models will get a 'green flag'. Those whose losses are well below the ECB's numbers will get an 'amber flag', prompting the ECB to press the bank involved to explain its methods.
Where banks were found not to have used the correct methodology, the results will get a 'red flag' and the figures will either be corrected or replaced with the ECB's assumptions.