LONDON (Reuters) - Most of Europe's big banks shed risky assets in the quarter to September, but they have yet to take extra provisions against doubtful loans to show they have put the financial crisis behind them in time for a critical review by regulators.
After reckless lending brought several banks and some governments to their knees during the global crisis, which is still playing itself out in a number of euro zone countries, next year's Asset Quality Review (AQR) by the European Central Bank will judge whether the banks have done enough to recognize and provide for losses on their loan books as of December 31.
The results feed into EU-wide stress tests that assess whether banks need to raise more capital to insulate themselves against future economic and financial shocks.
A Reuters analysis of the third-quarter results of Europe's 30 largest banks found that almost two thirds of the 27 that report detailed quarterly figures said their balance sheets were less risky at the end of September than at the end of June.
Cutting risk means they need less capital.
Assets such as unsecured personal loans, distressed commercial loans and certain derivatives carry a higher risk weighting, while government bonds are unweighted.
Swiss bank UBS cut 9 billion Swiss francs ($10 billion) of risk-weighted assets (RWA) in the quarter by exiting derivatives positions, while Spain's Bankia traded risky real estate assets with national "bad bank" Sareb for 19.5 billion euros ($26.6 billion) of government-guaranteed bonds.
But almost two thirds of the banks took lower charges for loan losses in the third quarter than a year earlier, and the 'coverage ratio' - what they set aside for losses relative to their stock of impaired loans - rose only marginally.
John Paul Crutchley, co-head of European banking at UBS, thought they would have increased provisions, drawing a parallel with the way U.S. banks position themselves and their balance sheets before the Federal Reserve's annual review, so the review won't unearth nasty surprises.
"It's probably because at the Q3 stage there was a complete unknown about how the ECB was going to conduct these asset quality reviews (in euro zone countries) and stress tests," London-based Crutchley added.
He and Berenberg's London-based banks analyst James Chappell expect to see more action in the fourth quarter, as banks learn more about the standards the ECB will apply in the euro zone and national regulators will apply elsewhere.
At a recent industry event in Brussels, the head of the ECB's AQR working group, Dutch regulator Anthony Kruizinga, was asked how banks should prepare their year-end statements if details of the AQR remain unclear. Banks should be more prudent, he replied. The DNB and ECB both declined to elaborate.
As things stand, coverage ratios vary widely across the EU, ranging from 94 percent at Commerzbank to below 50 percent at others. The ratios are difficult to compare across banks since they all use slightly different metrics, but are expected to be closely examined in the ECB's tests.
Banks were expected to improve the ratios in the run-up to the tests by taking more provisions, but coverage ratios rose on average just 3 percent in the year to September 30 among the 22 that report the data. Nine had lower ratios.
The bank with the biggest drop - Swedbank, down 18.5 percent - did not respond to requests for comment.
Hot on their heels, Spanish banks BBVA and Bankia cited factors including the transfer of real estate assets to Sareb, and changes mandated by their local regulator.
Stephen Smith, London-based head of transaction services at KPMG, said banks could also increase provisions in the fourth quarter if they believe another part of the ECB review - the Supervisory Risk Assessment (SRA) - might force them to give up on some types of assets, as portfolios in wind-down attract higher provisions.
Smith noted that banks' low margins and the 600 billion euro funding gap being filled by the ECB's long-term refinancing operation (LTRO), which provides cheap loans to banks, might suggest some banks don't have a viable mix of assets.
"If you're doing a Supervisory Risk Assessment asking yourself whether or not you've got a sustainable business model here, you can imagine the ECB would conclude that there's quite a lot of work to do," he said.
While banks are generally encouraged to take a prudent approach to assessing asset risk, global supervisors from the Basel Committee to the Bank of England have remarked upon the vagaries of RWAs and the scope for banks to manipulate them.
The ECB's head of financial stability Ignazio Angeloni told reporters the AQR could change a bank's overall RWA density - the relationship between total assets and RWAs - by moving loans from one risk category to another within a bank's own model.
In the third quarter, 16 of 27 European banks that give detailed quarterly reports had lower RWA density than a year earlier.
"Given the impact of riskier assets on RWA calculations, there is an incentive for banks to de-risk ahead of the AQR and stress test," said Jonathan McMahon, a partner at Mazars and a senior financial regulator in Ireland until 2012.
The banks with the biggest falls in RWA density cited changes in the make-up of their portfolios and denied that they were vulnerable to having their risk weightings forced up by regulators.
RWAs' role in the stress tests, which are being run by the European Banking Authority (EBA) across all 28 EU countries, is unclear. There have been talks about 'benchmarking' for RWA treatments to show how banks compare, putting pressure on those furthest from the norm. The EBA declined to comment.
"No-one's going to do anything until they've seen the actual details of what's going to happen in that review," said Berenberg's Chappell.
The bluntest tool banks have to avoid capital shortfalls based on their year-end position is to raise more capital before then, but Chappell doesn't expect that.
"If you're going to do it you're going to announce it as part of your results, because then you've got the full 2013 results for investors to look at," he said.
($1 = 0.8982 Swiss francs)
($1 = 0.7323 euros)
Additional reporting by Himanshu Ojha; Editing by Will Waterman