ECB needs to look beyond banking giants for signs of financial risk lurking within the system

SINCE taking over as the euro zone's main banking supervisor, the European Central Bank has spearheaded efforts to reduce the amount of bad loans that had cumulated throughout the great recession and the euro zone sovereign debt crisis.

This pile has fallen from 6.8 per cent of total loans at the peak in the December 2015 to 2.9 per cent in September 2019.

But critics, including the Bank of Italy, have insisted that the ECB has been blind to another risk lurking within the banking system: illiquid Level 2 and Level 3 assets, such as interest rate swaps or unlisted equity investments, which are hard to value and dispose of and can be especially problematic during these times of financial stress.

These assets sit on the balance sheets of many banking giants such as Deutsche Bank and BNP Paribas. In light of new research, the supervisor would be wise to monitor the level of these assets among smaller banks, too.

To be sure, Italy's warning was in part self-serving: the country had a particularly high proportion of bad loans, which has come down sharply only in recent years. But regulators and supervisors should certainly be asking whether they are doing enough to ensure that Level 2 and Level 3 assets won't contribute to the next financial crisis - especially since these played an important role in the 2008 crash.

The European Systemic Risk Board, the body in charge of monitoring threats to the financial system as a whole, has produced a study to examine the dangers behind these instruments.

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They suggest that supervisors pay greater attention to the exposures of mid-sized banks, which are often less transparent than Europe's banking giants in disclosing their assets.

The report documented a high level of heterogeneity in disclosing Level 2 and Level 3 assets by individual banks.

The authors looked at a sample of 22 lenders from the European Economic Area - including the 11 systemically important banks. They found that all the largest banks, including the likes of Deutsche Bank and BNP Paribas, have high levels of transparency.

Conversely, smaller banks are more cagey about what they hold. In fact, the amount of detail they give declines as the proportion of Level 2 and Level 3 assets increases.

This means that supervisors who are worried about the role of these instruments should also look beyond the usual suspects that are the larger banks. While these may be a concern for the size of their balance sheets, smaller lenders may have more to hide.

The report offers a list of sensible recommendations. These include demanding greater transparency from smaller, individual banks, and speeding up Europe's implementation of the "Fundamental Review of the Trading Book", a set of capital rules for trading activities that was internationally agreed upon by the Basel Forum last year.

However, the most important check on the real health of banks must come from supervisors monitoring individual ones. They need to verify that the valuations of individual assets and the models used to evaluate risk are realistic.

Level 2 and Level 3 assets need not be dangerous, so long as the ECB ensures they are properly accounted for. BLOOMBERG OPINION