Bank stress testing is a method used to identify probable economic events or conditions that adversely affect a bank’s credit exposures or the process of assessing a bank’s a ability to cope with such changes.
After the economic collapse of 2007, it has become ever so increasingly important to safeguard banks and financial institutions, depositors and the economy as a whole . To do that, banks are put through some of the most adverse scenarios to check whether they can withstand such shocks.
The following report discusses the stress testing of banks in the European Union which has 28 states . Some of the responsibilities that the EBA has are to ensure the systematic functioning of the financial system in the EU and the stability of that system. The European Bank Authority is mandated to monitor and assess market developments as well as identify trends , potential risks and vulnerabilities stemming from micro-prudential level .
The EBA Regulation gives the Authority powers to initiate and coordinate the EU-wide stress tests, in cooperation with the European Systemic Risk Board . The aim of the test is to provide supervisors, banks and other stakeholders with a common analytical framework to assess the strength in depth of European banks and European banking system adverse market conditions and to challenge the capital position of EU banks.
History
The first EU-wide stress testing were conducted in for the first time in 2009 by the committee of European Banking Supervisors ‘ CEBS, the predecessor of the EBA .The last EU-wide stress testing was carried out in 2016 . In 2013,-2014, the stress tests, initiated and coordinated by the European Banking Authority , were designed also in coordination with the ECB. It also carried a comprehensive review assessment at that time, in preparation of it becoming a single supervisor body. Hence the ECB needs all the information of underlying banking system. Comprehensive assessment comprises of risk assessment, asset quality review and stress testing .
EBA coordinates the stress test both , stress test being part of the comprehensive assessment review and those for member states outside the Euro zone . The same scenarios are used , but the only difference is of course is in sample mix .
The difference comes naturally from the geographical breakdown as pointed out from the journal of financial stability 'Cross-Border Banking and financial stability in the EU' . The exercise was conducted on a sample of 123 banks (at the highest level of consolidation), only for Eurozone countries versus the whole of European Union but also because of the level of consolidation and the predefined criteria.
EBA sample of banks covers at least 70% of the banking sector of each EU member state . It must be reminded in the case of the EBA sample, stress test are conducted on the highest level of consolidation as described in the Capital Requirement Regulation. Therefore, the perspective of single market is taken into account , meaning subsidiaries are not stress tested separately, but the consolidated group of each bank is.
The ECB sample of banks differs from the EBA for Eurozone. The ECB decided to include in comprehensive assessment banks with a balance sheet exceeding more than 30 billions Euro . The difference between the two sample results also from the level on which the stress tests are conducted .
The EBA sub-sample from the Eurozone banks is smaller because it is performed at the highest level of consolidation whereas the ECB will be testing subsidiaries if they meet its criteria. When the parent is outside the Eurozone and the subsidiary inside the Eurozone fulfils the ECB criteria, the EBA sample will cover the consolidated criteria of the group, ECB will then include the Eurozone subsidiary or subsidiaries depending on how many of them fulfil the criteria. But if the parent and the subsidiary are in the Eurozone, ECB will not test the subsidiaries separately .
Key aspects
The exercise assesses the resilience of EU-banks under a common macroeconomic baseline and adverse scenarios , which covers the period of 2016 to 2018. The time horizon and reference date is year-end 2015 to year-end 2018. The application of the market risk methodology is based on a common set of stressed market parameters, calibrated from the macroeconomic scenario, as well from historical experience, and on the haircuts for sovereign exposures. The credit risk methodology includes a prescribed increase in REA for securitisation exposures as well as prescribed shocks to credit risk losses for sovereign exposures.
The impact of the test is reported in terms of CET1 capital. Additionally, the Tier 1 capital ratio, the total capital ratio and the leverage ratio will be reported for every year of the exercise. No hurdle rate or capital thresholds are defined for the purpose of this exercise. Banks are not required to anticipate changes to the tax and accounting regime that comes into effect after the start of the exercise. It is also assumed there is no movement on the balance sheet for the purpose of the test . No change in business mix or geographical reach nor the reporting currency denomination of the balance sheet should change.
The approach is a bottom-up stress test. The primary focus of the assessment is to measure the risk drivers on the solvency of banks. Test should be carried out for credit risk, market risk and operational risk. In addition, the effect of the scenarios should be projected on the net interest income and on profit and loss account .
Process
The process of running the EU-wide stress testing involves several European agencies and Financial regulators to work in close cooperation , namely the EBA, the national competent authorities and the ECB, as well as the ESRB and European commission .
The development of the of the macroeconomic scenario and any risk specific shock linked to the scenarios are developed by the ESRB and the ECB, in close cooperation with competent authorities, the EBA and the European commission , which supply the macroeconomic baseline .
The EBA is the central actor for the competent authorities. It coordinates the exercise and defines the common methodology as well as the minimum acceptable quality assurance and answers all the concerns that they may have. The EBA provide data to all the member state for this common exercise. It also provides common descriptive statistics to the competent authorities to ensure that banks submissions are consistent .
The competent authorities are responsible for the following:
Conveying instruction to the bank and receiving information directly from the bank
For providing quality assurance in terms of data testing on the calculations from the model used
For reviewing the model used in the process by the bank
They may also carry out EU-wide stress test on samples beyond the one used for the EU-wide stress test
The supervisory reaction function and for the incorporation of the findings from the exercise.