From Fragmentation to Financial Integration in Europe
Chapter

Chapter 17. Stress Testing European Banks

Author(s):
Charles Enoch, Luc Everaert, Thierry Tressel, and Jianping Zhou
Published Date:
December 2013
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Author(s)
Daniel C. Hardy and Heiko Hesse 

The European authorities have used, and will continue to use, stress testing as a very prominent tool in crisis management, the analysis of banking sector stability, and the development of financial sector policy. Starting with the 2010 test led by the Committee of European Banking Supervisors and reinforced by the 2011 test and the bank recapitalization exercise led by the European Banking Authority (EBA), the output of EU-wide stress tests has been viewed as essential information on the health of the system.1 Moreover, the reliability of the results and the efficiency with which they were generated (especially the recapitalization exercise) have influenced the credibility of the European and national authorities involved. This prominence demands that future stress-testing exercises be very carefully designed and executed.

This chapter focuses on bank stress testing led by the EBA, and in particular on how to respond to changing circumstances and priorities going forward. The national supervisory authorities (NSAs), European Central Bank (ECB), and the European Systemic Risk Board (ESRB) conduct their own tests for various purposes, and this chapter will discuss those that have more or less Europe-wide relevance. Moreover, consideration will be given to both the solvency and the liquidity aspects of stress testing and how priorities are likely to evolve in the postcrisis environment, especially with the introduction of the Single Supervisory Mechanism (SSM). While the coordinated stress testing of nonbank financial institutions, specifically of insurance undertakings and pension funds, faces largely analogous issues, it will not be addressed directly in this chapter.

The chapter closely links to the wider discussion in the book on EU-wide crisis management and financial stability as well as the SSM. At the current juncture, repairing the balance sheets of European banks and smoothing the implementation of their strengthened prudential requirements and crisis management mechanisms are key. Stress-testing exercises can help toward these ends. Transparency and disclosure will be crucial not only regarding asset quality, but also regarding asset encumbrance, and the EBA will play an important role in promoting data quality and comparability (see Chapter 15 on EBA). Selective asset quality reviews (AQRs), coordinated at the European Union level, would also aid the ECB in the assessment of legacy assets for the SSM (see Chapter 3). Furthermore, with the continuing challenges on fragmentation and bank funding, especially in the periphery, the chapter argues for incorporating liquidity and structural elements in the design of postcrisis EU-wide stress tests.

Forthcoming Stress-Testing Exercises

The European authorities are expected to establish a regular cycle of coordinated bank solvency stress-testing exercises, with more emphasis on supervisory issues than in past exercises. One of the main supervisory issues in coming years will be the assessment of the realism, consistency, and robustness of banks’ capital plans to meet the phased-in capital requirements under the Fourth Capital Requirement Directive (CRD IV). The use of stress tests for crisis management purposes—generating pass/fail results and immediate recapitalization needs—is expected to diminish, especially with European banks already boosting their capital for the Basel III phase-in period given market and regulatory pressures.

Lessons from past stress-testing exercises will have to be incorporated into the design and execution of the forthcoming exercises, but modified as needed in light of current conditions and the exercise’s objectives. The improvements in efficiency and effectiveness seen since the 2010 Committee of European Banking Supervisors exercise should be extended, and in particular, the 2011 stress testing and recapitalization exercises offer additional lessons. Nonetheless, adjustments need to be made to allow for the fact that the situation of European banks is more diverse (also due to ongoing fragmentation, asset quality pressures, and funding strains) and also less uncertain than in 2010 or 2011. Some banks operate in program countries and others operate in a comparatively benign macroeconomic environment; some are heavily dependent on central bank refinancing and others have ample and excess liquidity, often deposited back at the ECB. Moreover, the tests need to be geared toward generating output and recommendations that are relevant for supervisory purposes, rather than those that are needed in an acute crisis situation. This section concentrates on identifying ways to reconcile these features in various aspects of the design of the exercise.

Publication and Transparency

The publication of detailed data on major European banks in the context of the 2011 stress testing and recapitalization exercises contributed to reducing uncertainty markedly and to the credibility of those exercises. The authorities were praised for providing enough information (more than 3,000 series, notably on sovereign exposures) that market analysts could check and with which they could run their own projections based on alternative scenarios and assumptions on banks’ treatment of their sovereign exposures. It is inevitable that analysts will want to assess the situation of banks assuming the immediate full implementation of CRD IV (already under way), and banks may be basing their own planning on this assumption. Had relevant data not been provided, the market would look on the exercise with increased skepticism.

The authorities will have to publish data from forthcoming exercises in at least as much bank-by-bank detail and also covering the initial situation of individual banks at the reference date, if not necessarily all projections. To do otherwise would, at least, miss an opportunity to reduce the uncertainty that has contributed to the fragmentation of funding markets, and could lead to suspicions that the authorities have bad news to hide. There should be a presumption that test results would be published in detail as well. Even if the authorities do not highlight certain series, such as the projected evolution of banks’ profitability, the information is valuable in the context of structural pressures on the sector. For instance, the 2011 stress test did not publish bank-specific data on the banks’ starting positions that were as comprehensive as the projections from the adverse scenarios. However, there may be scope to keep some details confidential. For example, publication of results from sensitivity analysis may be more confusing than reassuring, in part because the market could regard those results as benchmark results and penalize banks that do poorly in the sensitivity stress tests.

Confidentiality will have to be maintained over certain aspects of the supervisory recommendations. Some recommendations may relate to a bank’s confidential business planning, its detailed funding plans, or supervisors’ own policies. But a possible negative market impact should not in itself be grounds for nonpublication, since such market discipline is desirable. Consistent treatment across banks would be essential, not least to maintain a level playing field for competition.

In this connection, it is worth stressing that full disclosure of banks’ sovereign exposures (including those in the banking book) will be essential and that the tests will need to fully recognize the attendant risks. Given that the 2011 EBA recapitalization exercise involved marking to market banks’ sovereign securities’ exposure in the banking book (available for sale, AFS, and held to maturity), the market could be critical of a reversal. Admittedly, the Basel III rules envisage that just the trading and AFS books would be marked to market with a gradual phase-in period, while the held-to-maturity book would not be subject to marking to market. While authorities will have to trade off disclosure with the marking-to-market approach taken, relevant data should be published at a minimum. Nonetheless, if current market conditions persist, for most banks sovereign exposures are likely to be a smaller source of losses (or could contribute positively) in the baseline of the 2014 exercise. A relapse at least to recent peak sovereign spreads would be seen as constituting a plausible but not very extreme scenario. Hence, a conservative approach would probably not be disruptive. In any case, based on the disclosed detailed banking data, analysts would be able to calculate each bank’s estimated haircut on its total sovereign securities portfolio.

Consistency and Quality Control Mechanisms

The authorities are making strong and commendable efforts to improve quality control mechanisms. For example, reporting templates are being developed to incorporate various consistency checks, and there is expected to be ongoing contact between the authorities and banks to ensure that the methodology, benchmarks, and reporting forms are well understood. The 2011 experience suggests that the ECB top-down macro stress test need to be prepared and used as a crosscheck at an earlier stage, but to this end “clean-up” data needs to be provided to the EBA earlier on.2 In particular, NSAs need to make a quick but thorough check of data as soon as it is received.

As part of this process, the authorities need to continue to build up time series of statistical benchmarks for probability of defaults, loss given defaults, and default rates by granular counterparties, countries, and sectors, as well as ensure consistent application by banks of point-in-time estimates of probability of defaults and loss given defaults. Those benchmarks should be cross-checked with the ECB’s estimated probability of defaults and loss given defaults that are also being used to challenge banks and are adopted by banks under the standardized approach. Banks should use their point-in-time probability of defaults and loss-given defaults parameters for the bottom-up stress test and not through-the-cycle equivalents. The use of point-in-time parameters is important because results need to be sensitive to the scenarios, and the point-in-time probability of defaults is relatively forward looking. Stress tests are meant to say something about the ability of banks to survive bad points in time, so through-the-cycle parameters are not fully relevant to assessing resilience to conjunctural shocks.3

Reviewing Input Data

The banking systems of most program countries have been subject to detailed AQRs, and the question therefore arises of how to ensure consistency of input data. Elaborate and expensive “deep dive” AQRs have been carried out in individual banking systems in Europe and have formed a solid base upon which to conduct crisis stress tests. The IMF-European Commission-ECB “Troika” very much supported these efforts. Yet data from some of the non-program countries could conceivably contain important flaws, and a mere lack of consistency would make results difficult to interpret and could interfere with the internal market. In addition, some of the AQRs could be somewhat outdated if economic and financial sector developments have deteriorated more than initially forecast.

Inconsistencies may arise despite the (almost) universal application of International Financial Accounting Standards and a system of internal and external audits with supervisory oversight. First, the accounting standards allow some room for local differences in definition—for example, of a nonperforming loan or renegotiated/restructured loan. Second, interpretation of common definitions may differ across countries or banks. Third, interpretations may differ over time. In current circumstances, a bank may more readily choose to roll over a problem loan and make modest provisions, partly to help its borrower and partly to make its own results look better. It should be noted here, however, that consistency does not imply uniformity, as accounting differences may reflect underlying differences; probability-of-default and loss-given-default rates may genuinely differ, for example, because of large differences in bankruptcy laws and loan work-out arrangements.

Yet undertaking a full-blown AQR across the European Union would be very expensive, time consuming, and possibly counterproductive. Besides the practical difficulties and expense, announcing a comprehensive AQR would cast doubt on the integrity of past stress-testing exercises, national authorities, bank management, and the accounting and audit professions. Furthermore, consideration would also have to be given to undertaking an AQR for the assets of European banks outside the European Union, an enterprise that would add greatly to the complexity and cost.

In these circumstances, the authorities, coordinated by the EBA, need to give priority to unifying definitions of nonperforming loans and provisioning criteria. Efforts in this direction have been underway for some time, but now there should be momentum behind the project. Full implementation of all aspects might take place after the 2014 stress-testing exercise, especially for the SSM and the new supervisory role of the ECB, but that would not be a great drawback. There would need to be guidance offered to national authorities and the accounting and audit professions. While details for a comprehensive AQR as part of the SSM have yet to be decided, it seems likely to involve the ECB and the EBA as well as the NSAs. Overall, providing consistent and comparable banking sector data is among the responsibilities the (national) supervisors are accountable for.

Nonetheless, when a pressing need becomes apparent, it would be worthwhile to conduct limited reviews of input data, especially on asset quality. The focus would be on the most problematic sectors, and the stress-testing exercises would not be greatly impeded. Issues of special concern for such reviews are likely to include lender forbearance; impairment deficiencies; risk weighting and risk-weighted asset calculations by banks;4 collateral valuations and credit-risk mitigation techniques; and treatment of restructured loans. The main concern should be to make the reference period data as reliable as possible, as judged by the situation at that time; the baseline projection is meant to capture the evolution of impairments going forward.

Public explanation of the effort will need to be handled with care and measures taken to ensure that the exercise is recognized as rigorous but limited.5 In the publication stage, the EBA could promote the disclosure of granular asset quality information to enhance transparency and reduce market uncertainty about banks’ asset quality. However, there is a risk that investors could come to expect the revelation of additional losses in banks’ portfolios.6 Should the AQR reveal bank losses, questions will arise about recapitalization backstops at the national level (given that the ESM would not be able to provide capital prior to the SSM) and the inherent budgetary implications. Some data may be highly market-sensitive; rules of engagement in such case should be worked out in advance, especially if the ECB is involved in the context of the SSM. Also, evidence of underprovisioning that is unquestionably consistent with International Financial Accounting Standards might prompt tougher guidance in the stress-testing methodology on the future evolution of losses, rather than being reflected in published stock data at the reference date. The experiences of data disclosure from the external AQRs already conducted could be useful here. The credibility of the exercise would be increased by the involvement of outside evaluators, or at least peer reviewers, to limit the potential national bias.

Achieving Supervisory Orientation

Future stress-testing exercises are meant to be mainly for supervisory purposes, as opposed to the past emphasis on crisis management and the assessment of bank capitalization. Translating this intention into the design and practice of the stress test and transcending the market’s perception of past tests will require careful preparation. Market participants and analysts are likely to compare results across banks and try to quantify capitalization needs. If the capital needs are not “enough,” analysts may question the rigor of the tests. The tests need to be designed to meet supervisory purposes, which may demand that they be quite complex, but they also need to communicate credible messages, to which end the main tests need to be suitably calibrated.7

To achieve the supervisory purposes, the tests should yield recommendations for supervisors as bank managers and generate relevant indicators. Some of these recommendations, which may have to remain confidential, might include indications of the areas on which supervisors should focus their attention during the coming period (e.g., lending practices in especially vulnerable sectors or the sustainability of funding). To this end, it may be useful to generate relatively detailed projections, for example, for loan quality by sector and by country, capitalization by country, and profitability measures. Supervisory colleges could then discuss the implementation of these recommendations.

The authorities intend in particular to use the exercises to evaluate banks’ plans to comply with the evolving capitalization requirements under CRD IV. Each exercise is likely to follow a certain procedure: each bank will provide its dynamic capital plan, which will also include related planned adjustments among its assets and liabilities (e.g., a shift-out of assets with high capital weights or out of short-term market funding). Each bank will also provide data on its balance sheet positions at the reference period (e.g., end-2012), and projections of its profit and loss under the provided baseline and stress scenarios and satellite model guidance, but with a static balance sheet.8 A three-year projection period is typical. After checking plausibility and consistency, the authorities will substitute the projected losses and other elements from the two scenarios (baseline and adverse) into the bank’s capital plan. The authorities will then assess whether the bank’s capitalization level falls below, or close to, the CRD IV minimum requirements, such as on the definition of capital and risk-weighted assets, which are progressively tighter over the projection period due to the gradual phase-in period of CRD IV. If a bank’s plan looks precarious or is based on implausible assumptions, the relevant supervisor will demand a revision.

The use of a static balance sheet over three years may be justified mainly on the grounds of tractability and the desire to facilitate comparability. The stresstesting exercises are already highly complex, and allowing balance sheets to change would greatly add to the complexity: the methodology and consistency checks would need to be more complex, because they would need to cover the capital plans. Also, peer reviews would be less informative.

Yet the static balance sheet approach has distinct risks and other drawbacks if the aim is primarily supervisory. First, precisely because static balance sheets facilitate comparisons (more so than dynamic balance sheets), market analysts will be better able to interpret the results as a “beauty contest” among banks, as they seek out those that look comparatively or absolutely undercapitalized. Second, there is an inconsistency between the treatment of the considerable number of banks under restructuring plans agreed in the context of EU state aid rules, which will be assumed (as in the 2011 exercise) to implement those plans, and the treatment of the other banks. Third, there is an inconsistency between the macro projections, where monetary and financial aggregates change over the envisaged three-year stress-testing horizon, and the assumption of static balance sheets of monetary financial institutions. Fourth, there may be instances where a static balance sheet is inconsistent with other regulatory changes, such as those prompted by ESRB recommendations on foreign currency lending and the ending of long-term refinancing operations. Furthermore, market analysts also facilitate such a balance sheet adjustment by focusing not on the gradual CRD IV regulatory thresholds but on the fully phased-in ones.

The possibility of incorporating more dynamic elements into the balance sheet projections should therefore be kept under review, while comparability of the CRD IV definition should be ensured.9 It may be reasonably easy to provide banks with guidance on the evolution of major balance sheet components that are consistent with the macroeconomic scenario (for example, aggregate growth in deposits and credit by country or use of loan-to-deposit limits) and indicate that they should avoid strategies that rely on “deus ex machina” (such as the sale of an unprofitable business at a handsome price). Such a differentiation would also allow for the ongoing process of financial fragmentation and de-integration. As in the case of the 2011 recapitalization exercise, banks should not be allowed to optimize their risk-weighted assets. Adherence to such guidance would reduce the need to subject plans to preliminary evaluation before the stress test is performed.10 To ensure comparability across banks and jurisdictions, the stresstesting of CRD IV definitions and hurdle rates during the phase-in period should allow for no national discretion.

More effort in assessing the robustness of results, including the assumption of static balance sheets, would contribute to the results’ usefulness to supervisors and to their overall credibility. For example, sensitivity tests might involve re-running top-down tests with slight variations in the macro scenario or the satellite models, to see the extent to which results vary (possibly in a nonlinear manner). Top-down analysis could be used to quantify the effects of changing balance sheet size and competition to reflect projected aggregate changes (e.g., money supply and credit stock evolution), banks’ own plans, and the consistency of these elements. It may also be worthwhile to run tests for sensitivity to variations in input data.

Sensitivity to macroeconomic assumptions and projections needs to be assessed. Macroeconomic assumptions in the baseline and adverse scenarios play a crucial role in solvency stress tests, and can be key drivers for banks’ loan losses.11 It might be useful to use the ECB/ESRB top-down stress test for a country-specific sensitivity analysis of the adverse macroeconomic scenario. This could provide a sensitivity measure of banks’ resilience to the severity (or lack of severity) of the adverse macroeconomic scenario, especially since a common scenario might affect banks in specific jurisdictions in very diverse ways.

Long-Term Priorities

Refinement of satellite Models

The authorities have collected data and undertaken analyses that allow the plausible projection of many variables of interest onto both a baseline and an adverse scenario, but certain important series have proven to be especially difficult to model and deserve more research attention. In past stress-testing exercises, the projections of some series differed greatly across banks for reasons that were at best unintuitive, and these peculiarities may have weakened confidence in the overall results. Such inconsistencies—which are found even across banks from one country—can undermine stress-testing credibility and usefulness. The following series are important but have proven difficult to forecast (including in national stress-testing exercises):

  • Noninterest, nontrading income, which is of increasing importance to many banks and which may be disproportionately sensitive to a severe downturn. Banks’ projections of their fee income could be subject to some guidance by EBA, especially for the adverse scenario, to avoid banks using fee projections to compensate for loan impairments;

  • Trading income, which depends on banks’ own-account trading activity of both on- and off-balance-sheet items. Financial instruments in bank portfolios could be revalued at the prices prevailing in the scenario, rather than through the use of satellite models, which might not adequately capture banks’ trading income;

  • Funding costs, which depend both on exogenous or macroeconomic conditions, such as the sovereign’s credit rating, and on the bank’s own situation. As seen during the financial crisis, the banks’ cost of funding is linked to their capital buffers. Banks with lower solvency levels have seen either their funding costs sharply increase or their market funding channels closed entirely; and

  • Risk-weighted assets, which may be affected by shifts in risk weights and write-offs, even if the overall balance sheet is static.

Solvency and Structural Issues

As the situation of the banking sector changes and supervisory institutions evolve, it is worth considering where best to allocate limited stress-testing resources. There are already a great many stress testing and simulations done not only by the EBA but also by the NSAs, for their own stability analysis and supervisory purposes, and by financial institutions themselves for risk management generally, internal capital adequacy assessment process (ICAAP), and recovery planning/living will purposes. Some streamlining would be welcome. EBA could also have some enhanced role on giving guidance to banks on their recovery plan/living will stress testing.

Over the medium term, EBA could shift efforts to running tests on hitherto relatively neglected topics, such as structural issues and funding vulnerabilities. In this connection, competing EBA, ECB/SSM, and ESRB stress tests are to be avoided. Under the new SSM architecture, EBA should continue to closely coordinate the EU-wide stress tests with ECB and NSAs and ensure quality control; the ECB should run supervisory stress tests for the banks in the SSM; while ESRB should focus its contributions on macroprudential issues, such as the identification and calibration of systemic risk factors and the use of stress test results in formulating policy advise.

The EBA regulation gives the ECB a mandate to oversee stress testing. The ECB’s comparative advantages lie in such areas as (1) providing benchmarks and satellite models, especially for host-country operations;12 (2) ensuring that NSAs benefit from the latest techniques and apply them with full rigor;13 and (3) exercising its mandate to ensure that best use is made of stress testing by NSAs, for example in setting supervisory priorities and in evaluating banks’ recovery plans. Consistency in scenario building may sometimes be desirable but may be of lesser importance for supervisory purposes for many banks. In this light, the EBA may wish to focus in 2014–15 on improving liquidity stress testing and its integration with solvency tests, which is a relatively new area, rather than devoting so much of its limited resources to another comprehensive solvency test during this period (see below). Also, the EBA may have occasion to assess the use of stress testing by NSAs as part of its peer review process.

It would be valuable to run stress tests and related simulations designed to incorporate more long-term factors and generate lessons that relate more to structural issues. As emphasized above, the European banking system faces a prolonged period of low interest rates, possibly low growth, increased regulatory burden such as Basel III and CRD IV, and demographic change—developments that will put pressure on profitability, the supply of savings, and competition, among other challenges. Hence, the stress test scenarios need to encompass a longer time horizon; incorporate structural shifts (e.g., ongoing deleveraging and changes of bank funding profiles) affecting the balance sheet and income; and emphasize other metrics, such as profitability and changes in risk-weighted assets. It should be noted that stress tests and simulations are only one instrument in the toolkit to examine the structural challenges faced by banks and complement other quantitative and qualitative approaches. The ESRB would be the leader for efforts in these areas—in addition to its analysis of more conjunctural issues and nonbank sectors—which would be guided by the emerging consensus on best practice in macro-financial stress testing (Box 17.1).

Box 17.1Principles for Macro-Financial Stress Testing

A recent IMF document (IMF, 2012c) has brought together principles that summarize good practices and strategies for macro-financial stress testing. They may be summarized as follows:

  • Define appropriately the institutional perimeter for the tests.

  • Identify all relevant channels of risk propagation.

  • Include all material risks and buffers.

  • Make use of the investors’ viewpoint in the design of stress tests.

  • Focus on tail risks.

  • When communicating stress test results, speak smarter, not just louder.

  • Beware of the “black swan.”

Stress tests that make full use of market data (such as those based on contingent claims analysis) need to be developed further and used to complement balance-sheet-based tests, at least where such data are available.14 These methods, which are already deployed and being further developed by the ECB and some national central banks, are especially suited to capturing cross-sectoral and funding issues, for example by treating banks, nonbank financial institutions, and nonfinancial corporations on a consistent and integrated basis, and by linking sovereign and bank balance sheets. Furthermore, these models are intrinsically nonlinear and thus differentiate between behavior and pricing both in “normal” times and under stress conditions.

Stress tests might also be used to investigate the stability effects of the growth in “shadow banks.” The shadow banking sector is diverse, and some parts of it might be of much greater systemic importance than others (for example, due to linkages to banks or to effects on aggregate credit supply). Even simple stress tests might shed light on how important it might be to tighten the regulatory and supervisory framework for this sector. In particular, the implementation of structural reforms in the banking sector (e.g., the Volcker rule or the Liikanen and Vickers proposals), with the potential migration of some banking activities to the shadow banking sector, will over time further increase the importance of stress testing and examining the systemic implications of these shadow banking actors.

Liquidity Stress Testing

The financial crisis has highlighted the need to better integrate solvency and liquidity stress testing. A sharp rise in their euro and U.S. dollar funding costs, or quantitative rationing, was often the trigger for the failure of banks during the crisis and for the difficulties that many European banks continue to face. The EBA in its 2011 stress test introduced a cost-of-funding shock which, among others, was linked to the sovereign debt spread. The EBA in 2011 also conducted a less formal liquidity risk assessment, which indirectly captured fire sales through collateral haircuts.15 Elsewhere, the ECB in its recent Financial Stability Report has incorporated an explicit funding volume shock and deleveraging path into its macro stress-testing framework.16 The IMF (2012a and 2012d) has also been incorporating a dynamic deleveraging path in its analysis.

In the medium term, the EBA could intensify its work on liquidity stress testing, especially in the context of the phasing in of detailed common reporting templates on maturity mismatches, cost of funding, and asset encumbrance, as part of CRD IV.17 The EBA already has experience with liquidity stress testing, especially from its 2011 cash flow-based assessment of European banks. Such a liquidity risk assessment would test the resilience of European banks to various funding shocks (deposits, wholesale, and off balance sheet). It would also consider the banks’ behavior in response to more limited liquidity support such as, for instance, the tightening of central banks’ collateral requirements. The output could also feed into ESRB’s work stream on systemic risk assessments. The starting point for the EBA could be lessons learned from the 2011 internal EBA cash-flow-based liquidity risk assessment. The EBA could provide guidance on liquidity stress-testing issues and ensure some consistency of approaches by NSAs. It would likely need to boost its staff resources as well as adjust its medium-term work plan to incorporate such additional work on liquidity stress testing. It should also ensure the disclosure and transparency of the reporting templates and the overall liquidity stress-testing approach, while safeguarding sensitive results.

A cash-flow-based liquidity stress test, such as that used by EBA in 2011, offers certain advantages (see Schmieder and others, 2012). A cash-flow-based module along the lines of the 2011 internal EBA liquidity risk assessment or the forthcoming EBA cash-flow-based maturity mismatch template allows running detailed liquidity analysis, and hence it is well suited to capture a bank’s funding resilience and its liquidity risk bearing capacity. Cash-flow-based liquidity stress testing allows for detailed maturity buckets and can also be adapted to different currencies. Liquidity risk exposure (net funding gap, cumulated net funding gap) and liquidity risk-bearing capacity are clearly separated in the cash flow template. The template incorporates securities flows and ensures consistency between them and cash flows. This is especially important given the role that unsecured and secured wholesale funding play for many large banks. Off-balance-sheet activities such as foreign exchange swaps or credit and liquidity lines can be easily incorporated as well. Finally, the approach can incorporate the importance of banks’ asset encumbrance.18 Weaknesses of the cash flow approach include the high data intensity as well as initial set-up costs. While banks typically use a cash-flow-based approach for internal liquidity monitoring and liquidity stress testing, regulatory liquidity ratios are often based on stock accounting data, often with less data granularity than the cash-flow-based templates. The phase-in of EBA cash-flow-based maturity mismatch templates will provide regulators and banks with standardized templates that would need to be regularly filled out and reported. As with the EBA solvency stress tests, it is suggested that EBA staff have access to banks with NSA colleagues for a consulting/feedback process, and that they have direct interaction with banks’ liquidity risk managers so as to facilitate the rollout of such cash flow templates.

Conclusions

Stress testing has become an essential and very prominent tool in the analysis of financial sector stability and the development of financial sector policy, but in itself it can have only a limited impact unless it is tied to action. Stress testing and related simulations can serve various functions, such as the calibration of the relative importance of various risk factors and the assessment of banks’ capital needs when they are already under stress (e.g., Borio, Drehmann, and Tsatsaronis, 2012; IMF, 2012c; and Gray and Jobst, 2011). The publication of stress test results with enough supporting material (including on the initial condition of banks) can be helpful in reducing uncertainty (see also Jobst, Ong, and Schmieder, 2013); even banks that are revealed to be relatively weak may benefit if the market paralysis engendered by great uncertainty is relieved. But stress tests are of value mainly when they are followed up by concrete and swift actions by the authorities (supervisory and others) and by bank managers that improve the condition of banks and of banks’ clients.

The purpose of Europe-wide coordinated stress testing is changing, and therefore so should the design of these exercises change. The apex of the crisis in interbank markets and generalized worries over bank capitalization seem to be past (though pockets of weak banks remain). But European banks and the authorities responsible for financial sector policies face a drawn-out period of regulatory reform in a possibly unfriendly environment. The Europe-wide stress tests therefore need to be adapted in a way that ensures that they continue to yield extra value added, as compared to the stress tests conducted by banks themselves and by national authorities.

The planned 2014 exercise aims to generate analysis relevant to the assessment of banks’ capital plans during the gradual transition to the CRD IV requirements, rather than pass/fail results based on a single metric. Much effort has been and will be put into ensuring that methodologies are consistently applied, while reducing costs to participating banks as far as possible.

There remain a number of controversial issues, but experience suggests that the benefits of a bold approach outweigh the risks. A high degree of transparency, including on reference date data and on sensitivity to differences in definitions of input data, strengthens rather than weakens confidence and market functioning. The market would likely be critical if a wide range of detailed information on participating banks, and especially on their reference period conditions and (sovereign) exposures, were not published. Furthermore, uncertainty would be reduced by openness about data issues. Criteria for loan classifications and provisioning requirements differ across countries and, especially in current difficult conditions, banks may engage in some forms of forbearance: a bank may more readily choose to roll over a problem loan and make modest provisions, partly to help its borrower and partly to make its own results look better (see also IMF, 2013c).

To allay the most intense concerns, authorities should undertake selective AQRs, coordinated at the European Union level. Maximizing data consistency and quality will take time, and national supervisory authorities have the primary responsibility for the provision of consistent and interpretable banking sector data, but the EBA has an important role in coordinating and driving forward activities. Nonetheless, the Europe-wide exercise should acknowledge the caveat that data quality is probably uneven.

If the 2014 exercise is to focus on supervisory issues such as an assessment of banks’ plans to implement the solvency elements of CRD IV, then it should be designed and presented for this purpose; otherwise, markets are likely to follow past form and be fixated solely on capital shortfalls and relative weaknesses. To this end, the 2014 stress-testing exercise needs to generate operational recommendations and supporting indicators for supervisors. In this connection, it will be necessary to include the effects of the phase-out of the Long-Term Refinancing Operations provided by the ECB. Further efforts could be made to assess the sensitivity of results to likely changes in balance sheet composition, rather than assuming that balance sheets stay static. Otherwise, the results may not be very relevant for evaluating banks’ plans that involve significant balance sheet adjustment.

As the acuteness of the crisis diminishes, the identification of other vulnerabilities and issues, such as funding risks and structural weaknesses, will gain in relative importance (see also Kodres and Narain, 2010). Most major banks now seem comparatively well capitalized, but funding remains problematic for some, while the sector faces deep structural challenges relating to low profitability and growth and the longer-term impact of regulatory changes.

In the medium term, the European authorities and specifically the EBA could intensify their work on liquidity and funding stress testing, especially in the context of the phasing-in of detailed common reporting templates on maturity mismatches, cost of funding, and asset encumbrance, as part of CRD IV. Such a liquidity risk assessment would test the resilience of European banks to various funding shocks (deposits, wholesale, and off balance sheet). It would also consider the banks’ behavior when faced with more limited liquidity support (for instance, due to the tightening of central banks’ collateral requirements), and include risks from asset encumbrance (see also ESRB, 2013). The EBA could provide guidance on liquidity stress-testing issues and ensure some consistency in the approaches taken by NSAs. The EBA could also ensure the disclosure and transparency of the reporting templates and the overall liquidity stress-testing approach, while safeguarding sensitive results (see, for example, EBA, 2013).

It would be valuable to run European stress tests and related simulations designed to incorporate more long-term factors and generate lessons that relate more to structural issues. As emphasized above, the European banking system faces a prolonged period of low interest rates, possibly low growth, increased regulatory burden under Basel III and CRD IV, and demographic change. These developments will put pressure on profitability, the supply of savings, and competition, among other things. Hence, the stress test scenarios need to encompass a longer time horizon; incorporate structural shifts affecting the balance sheet and income (e.g., ongoing deleveraging and changes of bank funding profiles); and emphasize additional metrics, such as profitability. It should be noted that stress tests are only one instrument in the toolkit to examine the structural challenges faced by banks.

Efficiency and the need to avoid conflicting signals demand full coordination between the EBA, the SSM, and ESRB stress-testing exercises. For the 2014 exercise, the ECB could play a very active role, not only in making macro projections and top-down stress testing, but also, for example, in the review of input asset quality data. However, competing EBA, ECB/SSM, and ESRB stress tests are to be avoided. The EBA will still have a mandate to coordinate the EU-wide stress tests under the new SSM, working with the ECB and NSAs, and to ensure quality control. It should run supervisory stress tests for the banks in the SSM, while the ESRB should focus its contributions on macroprudential issues, such as the identification and calibration of systemic risk factors and the use of stress test results in formulating policy advice.

References

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The 2010 exercise was relatively poorly received: the stress scenario was regarded as too mild in the circumstances, and there was little assurance that banks had not been able to incorporate an optimistic bias into the results. Limited information disclosure did little to relieve the intense uncertainty prevalent at that time. The 2011 solvency stress testing and recapitalization exercises, which were led by then-new EBA, were better received. Those efforts were marked by extensive consistency checks, more transparency about methodology and data (for example, regarding sovereign exposures), and higher “hurdle rates”—that is, minimum capitalization levels expected of banks. Even though the final estimated capital shortfall was modest, that result was largely the product of many banks—especially those with relatively weak capital buffers—preemptively increasing their capitalization, and of what with hindsight appears to be unduly optimistic baseline and stress scenarios, including with regard to the treatment of sovereign risk.

In the 2011 EBA stress test, the ECB contributed the adverse scenario and top-down stress test, besides participating in the stress testing and quality assurance task forces.

It is possible that, if probability of default and loss given defaults are not sufficiently sensitive to the scenario, and risk-weighted assets decline over the scenario due to losses, the positive impact on capital (from lowering the risk-weighted asset—the denominator) may offset the limited impact of losses on capital (the numerator).

For instance, the recent Bank of England Financial Stability Report (November 2012) shows that banks’ risk-weighted asset calculations for the same hypothetical portfolio can differ vastly, with the most prudent banks calculating over twice the needed capital than the most aggressive banks.

Using a term other than “asset quality review” might be one element of the communication strategy that distinguishes this effort from the more comprehensive AQRs undertaken in program countries. “Asset quality data exercise” or “input data review” might be suitable titles.

It is possible that the exercise will reveal a sizable “hole” in the capitalization of some banks, even before any projections are made. The authorities will need to consider in advance how they would handle such a situation, for example, through immediate remedial supervisory action and exclusion of the affected banks from the regular stress test.

Insofar as the effects of risk factors are linear, calibration of shock magnitudes is not important for understanding how the system works.

The balance sheet is “static” in that it is not managed by the bank, but it will change as loan quality varies and capital is accumulated or depleted. Furthermore, the authorities envisage incorporation of the ending of the ECB’s long-term refinancing operations and the replacement of this financing with more expensive market financing.

Note that the external banking stress test conducted for Spain was based on a dynamic balance sheet assumption and banks’ capital plans.

In any case, assumptions need to be made consistent. For example, if the balance sheet is static, a well-capitalized bank cannot be expected to retain any dividends.

For the 2011 EBA stress test, the European Commission provided the baseline scenario, while the adverse scenario was given by the ECB/ESRB. EBA identified the microprudential risk factors and the ESRB, and the ECB then mapped them into the macroeconomic scenarios.

The EBA is well placed to provide common benchmarks for the hosted operations of banks that come from several home countries.

The EBA is already active in this area, as evidenced by its guidance on ICAAP evaluations and review of practices.

See Gray and Jobst (2011) and Gray, Merton, and Bodie (2007) for details on the contingent claims analysis approach.

The exercise was generally well designed, and some of its features will be useful in preparation for the introduction of the liquidity coverage ratio. Granular cash flow data, including by currencies and maturity buckets, for a broad sample of European banks (54), was compiled and checked. Multiple scenarios capturing the banks’ main liquidity risks and counterbalancing capacities were analyzed. On this basis, recommendations were conveyed to banks through the NSAs.

The ECB has not conducted stand-alone liquidity stress tests of Euro area banks. It does incorporate funding and liquidity stress indirectly via its contribution to the EBA solvency stress tests, where a funding cost shock is assumed. Furthermore, in the June 2012 ECB Financial Stability Report, an explicit funding volume shock is incorporated into the ECB macro stress-testing framework. The ECB approach does not, though, take into consideration its collateral and haircut policies or banks’ heterogeneous asset encumbrance levels.

Recent contributions on liquidity stress testing include Van den End (2008), Wong and Hui (2009), Aikman and others (2009), Barnhill and Schumacher (2011), and Jobst (2012).

Asset encumbrance lowers the resilience of a bank to further funding shocks by constraining its access to funding backed by suitable collateral; regarding liquidity risk, a bank that has encumbered much of its assets is in a similar position to one with few liquid assets. Either situation may undermine investor confidence.

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