(Oct 13): Lenders are loading up on capital to pass the European Central Bank’s balance-sheet exam on Oct. 26. Four years from now, some of it will count for nothing.

The ECB has spent a year pouring over the books of 130 of the euro area’s largest lenders in a Comprehensive Assessment intended, as President Mario Draghi put it, to “bolster confidence” in the banks. Yet the ECB’s rigor may be partly undermined by the test’s basic measure, the European Union’s capital rules.

The rules give national regulators, who remain in charge of the currency bloc’s banks until ECB supervision begins Nov. 4, leeway in how far and how fast they require lenders to deduct assets including goodwill and deferred tax assets. This leads to difficulties in comparing results across countries and potentially diminishes the value of a passing grade.

The assessment “may not be as rigorous as some would have hoped,” said Mascia Bedendo, an associate professor of finance at the Audencia Nantes School of Management in France. “There are still some caveats as regards how the capital may be computed in some countries. There’s the issue of deferred tax assets.”

To pass the Comprehensive Assessment, which consists of an Asset Quality Review and a stress test, banks must prove they can maintain a ratio of common equity Tier 1, a measure of a bank’s ability to absorb losses, to risk-weighted assets of 8 percent under current conditions and 5.5 percent under a simulated slump.

Hybrid Debt

Draghi said on Oct. 9 that since the summer of 2013, banks the ECB will supervise directly had “strengthened their balance sheets by almost 203 billion euros ($256 billion),” including 59.8 billion euros of gross equity issuance.

The rest includes hybrid debt and tax arrangements whose loss absorbency is largely untested.

Euro-zone lenders raised a total of 34.7 billion euros of equity in the first nine months of this year, according to data collected by Linklaters LLP. Italian banks led the way with 10.5 billion euros, according to the study.

EU rules, which implement global standards set by the Basel Committee on Banking Supervision known as Basel III, allow banks to deduct as little as 20 percent of these assets from their capital levels in 2014, increasing to 40 percent in 2015 and 60 percent in 2016, the final year covered by the ECB’s stress test. By 2018, they must be written down at 100 percent.

The leeway to apply these deductions is part of Basel III and EU law, so the ECB has no choice but to respect it. The capital definition of Jan. 1, 2014, applies for the Asset Quality Review, “whereas the definition that is valid at the end of the horizon will be used for the stress test,” according to the ECB.

Capital Rules

“On the deductions, the issue is that it’s up the member state how fast they implement them,” said Paulina Przewoska, a senior policy analyst at Finance Watch. “Whether you have to go up to 100 percent from year one or can take several years.”

The rules derived from Basel III come fully into force in 2019. The European Banking Authority, which is conducting the stress test in tandem with the ECB, will for the first time publish banks’ capital positions according to the 2019 standard.

Had banks been forced to implement capital rules fully at the end of last year, and deduct goodwill entirely, their core capital ratios would have been 12 percent lower, according to a September study by the European Banking Authority. Goodwill is an intangible asset that arises when a company is acquired for a price above book value.

The 42 biggest EU banks would have had a combined core capital shortfall of 11.6 billion euros ($14.6 billion) had Basel III been full enforced, the EBA said.

The use of deferred tax assets has emerged as one of the more controversial aspects of the ECB’s exam.

Tax Credits

Portugal has joined Italy and Spain in permitting the conversion of some deferred tax assets into credits that banks can count toward the capital they’re required to have on hand. Greece is pushing to join them, though a law on the conversions may not be passed in time, Kathimerini reported on Oct. 10.

“If banks overly rely on these types of deferred tax assets it becomes a concern,” said Stefan Best, a credit analyst at Standard & Poor’s. “It’s a weaker form of capital compared to common equity because it doesn’t give you the same comfort that this capital can absorb losses in times of stress.”

We believe it is reasonable that with the progressive implementation of Banking Union, such measures could be phased out, although we see this happening over an extended period of time.

Differing national interests and definitions of capital have dogged past attempts at examining the EU’s banks.

In 2011, the EBA’s tests were criticized for failing to catch problems early. Eight banks failed the exams with a combined shortfall of 2.5 billion euros, barely a 10th of some analysts’ expectations. Dexia SA, the French-Belgian lender, received a clean bill of health and then failed after a bank run three months later.

“This is so much better and will probably be much more informative than the previous exercises, but it isn’t perfect,” said Bedendo. “The ties between sovereigns and domestic banking systems are still very strong. The ECB needs to figure how strong these are and act to loosen them in the future.”

The ECB will analyze around 80 areas where capital rules are left up to national discretion, ECB Executive Board member Sabine Lautenschlaeger said in Vienna last month.

“We believe it is reasonable that with the progressive implementation of banking union, such measures could be phased out, although we see this happening over an extended period of time,” Andrea Filtri, an equity analyst at Mediobanca SpA, said in a report published on Oct. 9.