When will the ECB crack down on banks’ related party lending?

Will the European Central Bank’s asset quality review spot all the problem banks? Asset quality is a risk factor in the European Banking Authority (EBA) Comprehensive Assessment, but regulators may be missing a key underlying pattern in failure. Banco Espirito Santo has highlighted the issue of inter-related lending: loans to shareholders, affiliates and related parties. Because a complex circle of financing can easily escape auditors and regulators, it demands tough rules. After repeated bank failures, the ECB should recognise the specific challenges that arise from related-party lending.

After the financial crisis, the focus on systemic risk from Europe’s biggest banks is understandable. Certainly, leverage is an issue, and the focus on ringfencing retail operations is also understandable. But the collapse in 2008 of the Icelandic banks and Anglo Irish unearthed a murky circle of related transactions that had escaped scrutiny. This year history has repeated itself with Corporate Commercial Bank of Bulgaria (CorpBank) and Portugal’s Banco Espirito Santo. It looks as if regulators have learned nothing in six years. Only Ireland has brought in a specific code of practice on lending to related parties. This recognises the need for detailed regulatory powers whenever lending involves entities connected with directors, senior managers, shareholders or other related parties. It also noted that guarantees can, in effect, act as loans, often sneaking under the radar of conventional accounting.

Large shareholders, such as founding families, might be expected to maintain a strong focus on risk. But share interests can also create unhelpful incentives. Governance becomes confused, with directors facing competing pressures from investors who might also be clients. This can be magnified if a family or state-backed entity also has significant non-banking interests.

Stress tests, and even audits at a specific balance sheet date, can easily miss a bigger pattern that rotates financing and risk between different capital providers. It is time for this to be recognised as a specific risk, with material lending to affiliates seen as a clear red flag.

The banks now at risk may not be too big to fail, but can pose a major challenge for individual countries. Ireland and Iceland still bear the scars of their links with related-party lending. In Portugal, Banco Espirito Santo represented 20% of the nation’s bank lending, as its second-largest bank. And questions have been raised about the role of Bulgaria’s central bank, as the extent of CorpBank’s related-party lending is still not clear.

Even in the UK, Co-Op Bank’s problems remained under the radar for too long, with governance issues in the parent group compromising strategy. The problems showed that even a small bank in European terms can effectively be too big to fail. It is the vulnerability of its borrowers and depositors that matters. Blurred lines of control create a structural weakness in the banking sector.

With the EU’s bank resolution arrangements more than one year away, some of Europe’s smaller economies are still at significant risk. Letters of comfort and other guarantees given to those who might represent both liabilities and assets of a banking group, can be difficult to incorporate in a balance sheet. Auditors may not readily join the dots.

The complexity of bank and non-bank interests can easily swamp the local office of a global accounting firm. A bank may be small in European terms, yet pose specific risk in relation to a national economy or an individual audit office. There can be powerful bank owners such as state enterprises or family dynasties that exert control behind the scenes or influence specific loans. The result is that governance can be superficial, and possibly compromised by conflicting loyalties. An audit or regulatory review may not be able to look at financing flows and ownership implications that appear to lie outside a bank.

Will a stress test, focused on loan quality and leverage, easily pick this up? Banco Espirito Santo made a great play of avoiding state-backed loans in the financial crisis, when others were bailed out. In retrospect, this was not the signal of strength it appeared. For credibility, the ECB needs to show that its asset quality review will spot when relationships compromise good banking practice.

The EBA’s single supervisory mechanism will take over full responsibility for supervision of Europe’s largest banks in November. Its aim is greater balance sheet transparency. But a traditional approach to asset and collateral valuation has often failed when banks have incentives to mislead. The pattern in Europe for banks to own directly some industrial businesses creates conflicts of interest. Conflicting incentives involved in the web of financing used by some European banks demands a more pro-active approach to regulation. Dealing with relationships as footnotes to the accounts does not recognise how far some transactions might depart from good arm’s-length standards.

Banco Espirito Santo is a warning – it is important that the EBA and other regulators learn their lessons quickly. The EBA should pay more attention to intra-group leverage. There should be stricter rules on disclosure when a bank makes large loans to parties closely affiliated with large shareholders. The key is to make it harder for banks to disguise the identity of these types of borrowers. Ireland has taken the lead on how tough the rules need to be.

Greater transparency is essential, with the issues given far greater prominence in reporting. Without that, the EBA risks repeated embarrassment by failures of poorly governed banks. The credibility of the asset quality review is at stake.

A version of this article was published in Financial News an Op-Ed on September 22 2014.

Disclosure: The opinions expressed in this article are my own, and may not represent the views of any firm or entity with which I am affiliated. The information presented in this article has been obtained from sources believed to be reliable, however, I make no representation as to their accuracy or completeness and accepts no liability for loss arising from the use of the material. Articles and information do not represent investment advice.

Image credit; Colin McLean some rights reserved.

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