European Firms Feel Pressure Following Latest Round of Stress Tests

In July 2010, the Committee of European Banking Supervisors (CEBS), the former European regulator, issued a round of stress tests to assess the resilience of banks against an adverse but plausible scenario. While the levels of stringency were called into question by some critics (excluding the possibility of sovereign default from occurring, for example), the tests were widely accepted to be an important step to move forward in supporting the stability of the EU and euro area banking sectors; so much so that the European Banking Authority (EBA) made the tests an annual fixture – albeit with some amended key features in 2014.
 
Common methodology and scenarios, published by the EBA on 29 April 2014, ensure consistency and comparability of the outcomes across all banks. The elements that are being tested in this latest round of tests are widely regarded as the most conservative so far. The tests, which are to be conducted by all systemically important European banks, can be summarised under the following conditions:

  • Firms will be assessed under a period of three years (2014-2016).
  • Firms will be required to stress a common set of risks including: credit risk, market risk, sovereign risk, securitisation and cost of funding. Both trading and banking book assets will be subject to stress, including off-balance sheet exposures.
  • In terms of capital thresholds, 8% Common Equity Tier 1 (CET1) will be the capital hurdle rate set for the baseline scenario and 5.5% CET1 for the adverse scenario.

The adverse scenario reflects the systemic risks that are currently assessed as representing the most pertinent threats to the stability of the EU banking sector: (i) an increase in global bond yields amplified by an abrupt reversal in risk assessment, especially towards emerging market economies; (ii) a further deterioration of credit quality in countries with feeble demand; (iii) stalling policy reforms jeopardising confidence in the sustainability of public finances; and (iv) the lack of necessary bank balance sheet repair to maintain affordable market funding.

The negative impact of the shocks, which also include stresses in the commercial real estate sector, as well as a foreign exchange shock in Central and Eastern Europe, is substantially global. In the EU, the scenario leads overall to a cumulative deviation of EU GDP from its baseline level by -2.2% in 2014, by -5.6% in 2015, and -7.0% in 2016. EU unemployment is higher than its baseline level, by 0.6 percentage points in 2014, by 1.9 percentage points in 2015 and by 2.9 percentage points in 2016.

The EU-wide stress tests will be carried out in conjunction with the European Central Bank. In tandem with the EBA’s plans, the ECB is currently finalising the asset quality review (AQR) in advance of its supervisory role of assuming full responsibility for supervision as part of the single supervisory mechanism (SSM).  As well as the supervisory risk assessment to review key risks, including liquidity, leverage and funding, and the asset quality review (AQR) to enhance the transparency of bank exposures, the assessment includes the stress test to examine the resilience of banks’ balance sheet to stress scenarios.

Meanwhile, firms in the UK have additional stress scenarios to take into consideration, as outlined in the April 2014 paper ‘Stress testing the UK banking system: key elements of the 2014 stress test’ and the October 2013 discussion paper ‘A framework for stress testing the UK banking system.’ These publications, produced by the Bank of England under the guidance of the Financial Policy Committee (FPC) and the Prudential Regulation Authority (PRA) Board, set out proposals for annual, concurrent stress tests of the UK banking system. A key threshold for the UK test will be set at 4.5% of Risk Weighted Assets (RWA) to be met with CET1 capital in the stress.

Stress scenarios include a record 35% fall in residential property prices and a 30% slump for commercial property, after a sharp rise in interest rates. If a firm’s capital ratio is projected to dip below this mark, then the PRA will step in and require the firm to strengthen its capital position. The BoE’s focus on property prices comes amid fears that the UK market is once again overheating, with UK house prices nearly 10 per cent higher than a year ago in March.  The Bank of England’s scenarios are tougher than the EBA’s but a lower level of capital is needed. The Bank of England test results will be published after the EBA’s, which are due in October.  

This level of collective fastidiousness in Europe regarding stress tests is no surprise, as there is still some way to reach the levels of trust and confidence seen pre-crisis. For example, the 2014 Edelman Trust Barometer shows that the EU is the least trusting of the financial services industry by region. Furthermore, when considering news from the US Federal Reserve’s that five major banks out of 30 failed its Comprehensive Capital Analysis and Review (CCAR) earlier this year, it is no surprise that the heat is on for EU firms.  However, while many different factors are being explored and will undoubtedly give the regulators a comprehensive ‘health check’ of the firms within their respective remits, will they do enough for firms to set adequate bank capital levels?

First, one could question why the EBA and ECB are analysing static balances only – in order to obtain an adequate view on emerging risk, one could argue that dynamic analysis is as important. The assumption of no new growth and constant business mix and model throughout the time horizon of the exercise is very conservative because the banks’ capacity to react to an adverse situation is not taken into account. The tests run in the UK and US admit dynamic balance sheets.

Second, there are known knowns – things we know. There are known unknowns – things we know we don’t know. But there are also unknown unknowns – things we don’t know we don’t know. Having a stress testing framework will likely not protect you from the unknown unknowns. Financial crises tend to begin in sectors where they are least expected. It is likely these will not be incorporated in the stress analysis.

Finally, many banks are in the process of integrating finance, treasury and risk in delivering the enterprise stress tests, however many are not there yet. Stress testing controls should be as robust as those used for finance processes. The risk and finance models used to project data under adverse stress scenarios need to be of the highest quality. Stress test processes should not be standalone or siloed processes.  In order for them to be effective, stress testing processes need to be aligned not only with regulatory requirements and Internal Capital Adequacy Assessment Process (ICAAP)/Individual Liquidity Adequacy Assessment (ILAA) processes but also with business strategy and budgeting processes.

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