The future of Europe-wide stress testing

Daniel Hardy, Heiko Hesse 20 April 2013

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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 can have only a limited impact unless it is tied to action (see IMF 2013b). 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 et al. 2012, IMF 2012, 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 et al. 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.

Stress testing is changing

The purpose of Europe-wide coordinated stress testing is changing, and so therefore should the design of these exercises. This column draws lessons from past exercises (especially those led by the European Banking Authority) for future efforts, and also considers how changing challenges should affect the design. The apex of the crisis in interbank markets and generalised worries over bank capitalisation seems to be past (though with pockets of weak banks). But European banks and 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 compared to the stress tests conducted by banks themselves and by national authorities.

Background

Coordinated European stress testing began with the 2010 exercise led by the Committee of European Banking Supervisors. It 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 recapitalisation exercises, which were led by then-new European Banking Authority, 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 capitalisation levels expected of banks. The exercises succeeded in prompting banks to increase the quantity and quality of their capitalisation, and contributed to a reduction in uncertainty and an increase in the credibility of the process. Even though in the 2011 European Banking Authority-led stress testing exercise the final estimated capital shortfall was modest (see European Banking Authority 2011), that result was largely the product of many banks – especially those with relatively weak capital buffers – preemptively increasing their capitalisation, and of what with hindsight appears to be unduly optimistic baseline and stress scenarios, including with regard to the treatment of sovereign risk. But banks raised more than €200 billion in capital by the conclusion of the recapitalisation exercise (see EBA 2012). However, confidence in European banks is not fully restored, in part because the market suspects some banks of having been insufficiently transparent – including as part of the stress-testing exercises – about their losses and exposures to problem sectors. Such suspicions come on top of concerns about the macro environment, banks’ longer-term profitability, and sovereign risk. 

The 2013 stress-testing exercise

Lessons from the past stress tests are being used to strengthen and streamline procedures for the planned 2013 exercise. That exercise is likely to involve three-year projections under a baseline and a stressed scenario. Much effort has been, and will be put into ensuring that methodologies are consistently applied, while reducing, as far as possible, costs to participating banks. A major objective is to generate detailed analysis relevant to the assessment of banks’ capital plans during the gradual transition to Capital Requirement Directive IV requirements, rather than pass/fail results based on a single metric.

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 condition 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 asset quality reviews, coordinated at the EU level. Maximising data consistency and quality will take time, and national supervisory authorities have primary responsibility for the provision of consistent and interpretable banking sector data but the European Banking Authority 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 2013 exercise is to focus on supervisory issues such as an assessment of banks’ plans to implement the solvency elements of Capital Requirement Directive IV, then it should be designed and presented for this purpose; otherwise, markets are likely to follow past form and be fixated just on capital shortfalls and relative weaknesses. To this end, the 2013 stress-testing exercise needs to generate operational recommendations and supporting indicators for supervisors. 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 it stays static. Otherwise, the results may not be very relevant for evaluating banks’ plans that involve significant balance-sheet adjustment.

Longer-term priorities

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 capitalised, 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 European Banking Authority could intensify its 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 Capital Requirement Directive 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’ behaviour 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 European Systemic Risk Board 2013). The European Banking Authority could provide guidance on liquidity stress testing issues. The European Banking Authority would also ensure the disclosure and transparency of the reporting templates and the overall liquidity stress-testing approach, while safeguarding sensitive results (see for example European Banking Authority 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 emphasised above, the European banking system faces a prolonged period of low interest rates, possibly low growth, increased regulatory burdens under Basel III and Capital Requirement Directive IV, and demographic change. These developments will put pressure on profitability, the supply of savings, competition, etc. Hence, the stress tests 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 emphasise other 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 demands full coordination between the European Banking Authority, the Single Supervisory Mechanism and the European Systemic Risk Board stress testing exercises. For the 2013 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 European Banking Authority, ECB/ Single Supervisory Mechanism and European Systemic Risk Board stress tests are to be avoided. The European Banking Authority will still have a mandate to coordinate the EU-wide stress tests under the new Single Supervisory Mechanism, working with ECB and NSAs, and to ensure quality control. The ECB should run supervisory stress tests for the banks in the Single Supervisory Mechanism, while European Systemic Risk Board 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.

Disclaimer: The views expressed here are those of the authors and are not necessarily those of the institutions with which they are affiliated.

References

Borio, Claudio Mathias Drehmann and Kostas Tsatsaronis (2012), “Stress-testing macro stress testing: does it live up to expectations?”, BIS Working paper No. 369, January 2012.

European Banking Authority (2011), “European Banking Authority 2011 EU-Wide Stress Test Aggregate Report”, EBA, London, July.

European Banking Authority (2012), “Final report on the implementation of Capital Plans following the EBA’s 2011 Recommendation on the creation of temporary capital buffers to restore market confidence”, EBA, London, October.

European Banking Authority (2013), “Consultation Paper, Draft Implementing Technical Standards, On Asset Encumbrance Reporting under article 95a of the draft Capital Requirements Regulation (CRR)“, EBA, London, March.

European Systemic Risk Board (2013), “Recommendation of the ESRB of 20 December 2012 on funding of credit institutions (ESRB/2012/2)”, Frankfurt, February.

Gray, Dale F, and Andreas Jobst (2011), “Modeling Systemic Financial Sector and Sovereign Risk”, Sveriges Riksbank Economic Review, September.

International Monetary Fund (2012), “Macrofinancial Stress Testing—Principles and Practices,” August.

International Monetary Fund (2013a), “European FSAP: Financial System Stability Assessment (FSSA)”, IMF, Washington, March.

International Monetary Fund (2013b), “European FSAP: Technical Note on Stress Testing of Banks”, IMF, Washington, March.

International Monetary Fund (2013c), “European FSAP: Technical Note on Progress with Bank Restructuring and Resolution in Europe”, IMF, Washington, March.

Jobst, Andreas A, Li Lian Ong and Christian Schmieder (2013), “An IMF Framework for Macroprudential Bank Solvency Stress Testing: Application to S-25 and Other G-20 Country FSAPs”, IMF Working Paper 13/68.

Kodres, Laura and Aditya Narain (2010), “Redesigning the Contours of the Future Financial System”, IMF Staff Discussion Note No. 2010/ 10.

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Topics:  International finance

Tags:  banking, stress tests

Chief, Debt and Capital Market Instruments Division, IMF

Economist in the Strategy, Policy, and Review Department, IMF

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