By Laura Noonan and Eva Taylor
LONDON/FRANKFURT (Reuters) - Banks across the European Union will be asked to use a single definition for bad loans in the upcoming review of their loan books, a senior EU regulatory source told Reuters, making it harder for banks to conceal the state of their businesses behind local conventions.
The European Central Bank (ECB) hopes to begin work on an asset quality review of major banks in the seventeen euro zone countries later this year.
The review will take a detailed look at whether they've set aside enough cash to deal with debts unlikely to be repaid, so the ECB can stand over the state of the banks' before it becomes their official supervisor in late 2014.
National supervisors elsewhere in the EU will conduct a similar review for the non-euro zone countries. Both reviews, which will be co-ordinated by pan-EU regulator the European Banking Authority, will focus on 'problem categories' of loans in individual countries, looking at areas like shipping, commercial real estate and mortgages in some markets.
A senior EBA source told Reuters a key feature of the asset quality review will be harmonizing the way banks categorize loans. EU supervisors use a host of different ways to classify troubled or non performing loans, making it difficult to compare across jurisdictions.
The EBA recently carried out a consultation on a single definition to be used across the EU and is working on firming up that definition by September, so it can be applied in the assets quality reviews.
"We'll be asking everyone to use those single definitions," said a senior EBA source.
In a note published on August 14, Moody's Analytics said harmonized NPL definitions would "set the foundations for a new European standard for stress testing".
"These standards will also give the ECB's supervisory role much greater credibility when the banking sector and investors need it most," the note from Moody's Analytics managing director Alessio Balduini added.
An ECB spokeswoman there had not been a final decision on the treatment of non-performing loans.
The 2011 version of the stress tests, which relied entirely on national supervisors' submissions and definitions, was widely criticized for finding that Europe's 70 largest banks collectively needed just 106 billion euros ($140.62 billion).
The EBA is keen to ensure this round of stress tests has more credibility, and sees consistency of definitions and transparency of information as a key way of ensuring this.
The stress tests are more forward-looking, and examine how banks would cope with future scenarios like a collapse in economic growth, a rise in interest rates or another credit crunch that made it far harder for them to access funding, essentially answering a different question.
Rather than having a pass/fail mark, like previous tests, the 2014 version will rank banks against various yardsticks.
Those could include examining their coverage ratios, or how many cents banks have set aside to cover potential losses for every euro of bad loans, a senior EBA source said.
The EBA is also encouraging more transparency in the way banks judge the riskiness of their portfolio, a key input into the capital ratios.
To further this, the stress test could include benchmarks showing how conservative or aggressive banks' risk weighted assets treatments are, the source said.
(Reporting By Laura Noonan, Editing by Thomas Atkins)