Large European banks now know a lot more about what's expected of them in the forthcoming stress testing exercise, coordinated by the European Banking Authority (EBA). The stress scenario will be more severe than in previous exercises, and supervisory scrutiny more intense. The exercise has been some time in the planning and banks now need to take action. The outcome of the recent US Federal Reserve's stress testing exercise highlights the potential dangers of shortcomings in banks' approaches to stress testing, quite apart from the numerical outcome of the test.
The EBA yesterday published details of its 2014 EU-wide stress test. 124 European banks will take part (the full list can be found here). For those banks headquartered in the Eurozone, the exercise will form part of the ECB's ongoing comprehensive balance sheet assessment exercise in preparation for the Single Supervisory Mechanism (SSM). In the UK, the Bank of England announced it will run a variant of the EBA's exercise and extend the sample to capture the eight major UK banks.
The exercise will be conducted in coordination with other European institutions and with national supervisory authorities. The EBA will act as the 'data hub' for collation and publication of the results. Practically, day to day responsibility remains with national supervisory authorities, who will be primarily responsible for any decisions on how to implement the approach, and for checking results. For Eurozone banks, the ECB will fulfil the role of 'national supervisor'. For those banks in particular, the broader perspective the ECB brings may mean a greater degree of peer-group benchmarking and challenge than was the case in previous exercises.
The final design of the exercise is consistent with the main features highlighted earlier this year and reported in our blog ' EU banking stress test | EBA fires the starting gun'. Banks' resilience will be tested against a baseline and an adverse macro-economic scenario. Banks will be required to meet a minimum Core Equity Tier (CET) 1 ratio requirement of 5.5% under the adverse scenario. The adverse scenario assumes that by 2016, on average across the EU, GDP falls by 7.0% (versus positive growth each year in the baseline scenario), with unemployment rising to 13.0% (versus 10.1% in the baseline scenario). EU real estate values decline significantly, with residential property down 21.2% and commercial property down 14.7%. The scenario also simulates significant currency declines for a number of Eastern European counties.
The EBA expects to publish the final results of the stress test in October, alongside the results of the ECB's comprehensive balance sheet assessment exercise. Results will be disclosed on a bank by bank basis, and will include the capital position of banks, risk exposures and sovereign holdings.
Key considerations for banks
- This exercise underscores the growing importance of stress testing, and is the latest step in a long-running trend. All banks will be familiar with stress testing, and many will have participated in previous EBA exercises. That experience will provide a useful reference point.
- However, the past is not necessarily a good guide to the future. Supervisory expectations continue to evolve. This is not only about clearing the hurdle rate – firms will be expected to deliver good practice in execution too. The recent results of the US Federal Reserve's exercise highlighted the importance of getting the process right.
- In our experience, resourcing and governance are often paid insufficient attention in designing a stress testing programme. The challenges in this area will be particularly acute for Eurozone banks already delivering the asset quality review (AQR). For all banks, it is important that the process is coordinated so that the right stakeholders, including senior management and the Board, can input in a timely manner.
- The AQR exercise has highlighted the importance of banks having their data organised, available and validated to provide a sound basis for the application of the stress tests. Experience shows that this process can be time consuming and complex. The sooner banks make a start on this the better.
- Although the EBA has provided a large amount of detail to run the stress test, banks will need to make some of their own assumptions in order to map the scenarios to their business. Judgments at this stage are crucial and it is important that banks draw on the right expertise internally. Banks, in particular in the Eurozone, will have limited opportunities to correct their homework before the results are published because of timetable constraints.
- For Eurozone banks, how the AQR and stress test exercise are ultimately to be joined up is still under review by the ECB, but we expect details on the specifics of the join up to be released in May. Clearly it will require trade-offs to be made between rigour and timeliness. The approach will directly affect the numerical outcome of the stress tests.
What will the exercise look like for banks in the UK?
The Bank of England will not run an entirely separate exercise to the EBA's as it implements a new framework for stress testing the UK banking system. Instead, it will take advantage of the national discretion permitted by the EBA to apply shocks on top of the EU-wide scenarios. The 'UK variant' scenario is more severe. It assumes an initial fall in sterling of around 30%, which leads to inflation and triggers a monetary policy response (the EBA scenario assumes no policy response). Residential house prices are assumed to decline 35% on average, compared to an assumption of 19.2% for the UK by the EBA. Commercial real estate prices decline 30%. Banks have been asked to include a dynamic response to the stress scenario, which contrasts with the EBA's static balance sheet assumption.
To ensure the results can be interpreted alongside the Bank of England's ongoing assessment of banks, the definition of capital will be based on the fully-implemented CRD IV definitions (the EBA will use transition definitions) and a minimum capital ratio threshold of 4.5%. For the baseline scenario, the banks will be assessed against a 3% leverage ratio target, in addition to a risk-weighted capital ratio.
Further details of the exercises can be found through the following links:
- EBA publishes common methodology and scenario for 2014 EU-banks stress test
- Bank of England 2014 stress testing exercise
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