These stress tests are based on a combination of global economic weakness (negative real GDP growth and high unemployment); increases in short-term and long-term interest rates, and a widening of spreads between sovereign long-term bond yields; and sharp falls in equity and property prices.
Banks are then left to feed these shocks to macro and financial variables into their capital ratios over the next three years, through their net interest margins, loan and trading book valuations and losses, and risk weighted assets. The resulting capital ratios are then compared against a “hurdle rate” – which again differs slightly between the EBA and UK tests.
The results of the stress tests will be published in the final quarter of this year, and supervisors (including the ECB for the banking union area) will discuss with banks what actions are required to meet any identified capital shortfalls.
It remains unclear to what extent supervisors across Europe will examine in detail the systems and processes used by banks to convert the scenarios into the impact on capital ratios. But there is likely to be an increasing emphasis on this, following
the lead taken by the US Federal Reserve Board. The Bank of England is clearly moving in this direction, and the ECB is likely to take a similar approach once it is fully established as a supervisor.
This is important for financial institutions because:
Supervisors are increasingly using stress tests as a means of imposing tougher capital requirements than are set in the minimum capital standards. The tougher the stress test, the higher the number of banks that will fail the test, even if they currently meet minimum capital standards on an un-stressed basis.
Banks that “fail” the tests will be required to improve their capital ratios, and will be under pressure to achieve these improvements as soon as possible. For banks in the banking union, this may reinforce the pressure on banks to adjust in response to the results of the Asset Quality Review (AQR). Indeed, banks that may need to adjust in response to the AQR and/or the stress tests are being encouraged to improve their capital positions now, rather than wait until the full results are available.
Supervisors in Europe are also likely to follow the lead of the US Fed in focusing increasingly on whether banks have adequate processes and systems to convert macro and financial variable stress tests into an impact on capital ratios. The US Fed announced recently that five (out of 30) bank holding companies had failed this aspect of its recent stress test (the Comprehensive Capital Analysis and Review), even though only one of these banks showed a capital shortfall.
Possible implications for banks
The proposals will add to banks' costs and potentially limit their business activities:
- The EBA’s latest stress test (and even more so the UK version) is more severe in many respects than earlier versions, including the assumptions on sovereign debt;
- Banks that fail the test will be required to improve their capital ratios;
- Banks with large exposures to property and to sovereign debt may be hardest hit by the stress test;
- Supervisors can also supplement the stress tests with bank-specific considerations (for example where individual banks have exposures that are not well captured in the common stress test);
- The ECB will be keen to use the AQR and the stress tests results to “draw a line” ahead of taking on its supervisory responsibilities in November this year – so it is likely to take a tough approach in response to the results;
- Banking groups operating across countries will face high costs from having to undertake different stress tests in different jurisdictions; and
- As in the US, supervisors are likely to focus not just on the results of the stress tests but on the ability of banks to undertake them effectively – so the focus may shift towards systems and processes.
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