EU stress tests in 2016 – Are European banks ready for the shocks?
November 11, 2015
The European Banking Authority (EBA) has announced that it is due to conduct a stress test on European banks during the first half of 2016 similar to the EU-wide stress test in 2014.
In 2014 the EBA stress test placed considerable emphasis on credit risk in terms of the impact of the increase in non-performing loans on net income. The stress testing followed an Asset Quality Review (AQR) that reviewed the bank’s assets and impairment policies. At that time 24 banks fell below the 5.5% CET1 threshold with an overall shortfall of nearly €25bn over the three-year horizon of the exercise.
Since the start of the financial crisis in 2007, we have become accustomed to large losses being reported by banks, many of which have resulted from asset impairments. The latest loss announcement came in early October from Germany’s biggest bank, Deutsche Bank. It blamed huge impairment charges of €5.8bn for turning its forecasted profit of around €1bn into a loss. A recent IMF ’blog’ found that the financial crisis has left the EU with high levels of non-performing assets which are a drag on both credit and GDP growth.
Senior management teams need to understand the risks in their organisation and ensure that strong systems and processes are in place to support proper decision making and to protect the assets on behalf of shareholders. Implementation of robust systems may attract some additional cost but long-term benefits should arise from clearly understood business decisions and potentially lower capital requirements. This is particularly important as systems need to properly support upcoming regulatory requirements, one of which is the EU-wide stress testing exercise in 2016.
What is stress testing and what will the EU 2016 stress test involve?
Stress testing is a forward looking view of a bank’s ability to absorb shocks under stress. It is also an important risk management tool as it gives an indication of the riskiness of a bank’s exposures. The stress test covers credit risk, market risk, sovereign risk, operational risk, securitisation risk, risk to non-interest income and expenses as well as the risk to cost of funding.
The 2016 stress test will be similar to the EU-wide stress test of 2014. It will be based on a constrained ‘bottom-up’ approach, including a static balance sheet assumption and with a wide risk coverage (e.g. market, credit and operational risk) to assess EU banks' solvency. Interestingly this means it will be conducted on a different basis to the dynamic stress tests undertaken by the Prudential Regulation Authority (PRA) in the UK, meaning a number of UK banks having to undertake both a static and dynamic stress test.
The dynamic stress test allows for changes to the business mix in a stress scenario, whilst in a static stress test the business mix and model remains constant throughout the stress period. So maturing assets and liabilities must be replaced with similar instruments and no workout or cure nor any capital measures are allowed.
What did the 2014 stress tests tell us?
1. Sustainable tools and methodologies
The 2014 stress testing exercise required significant investment from banks both in terms of time and resources as the banks were not fully prepared. I expect the 2016 exercise will again present a significant challenge.
Previously stress tests were overly reliant on spreadsheets and were hugely time consuming for those compiling the data. Investment would allow the banks to conduct business as usual in parallel with regular internal stress testing exercises to be so much more streamlined. This would allow the individuals in risk management to concentrate on the very real and actual risks the bank is really faced with.
There are other aspects to consider too. A longer term, more strategic implementation could be considered in line with the implementation of BCBS 239, i.e. the Basel Committee on Banking Supervision’s guidelines on Principles of effective risk data aggregation and risk reporting.
It may also be sensible for banks to consider the requirements arising from the Banks Recovery and Resolution Directive (BRRD) and how these requirements could be combined with a robust stress testing framework.
Finally, and most importantly, such a framework would allow management teams to be better informed of normal day-to-day business risks.
2. Governance and control
A central part of any regulatory request is management ownership of the deliverable. So the controls and governance put in place by management teams play a critical role in regulatory exercises such as stress testing. While the EBA stress test is a quantitative exercise, the qualitative aspects will become increasingly important if the EBA exercises develop into more of a dynamic stress test in line with the stress tests in the US and the UK.
The EBA stress testing templates in 2016 are similar to the templates used in the EU-wide stress test in 2014. So it is even more critical that there is a robust review and challenge framework in place given the extensive volume of data and the manual nature of the excel spreadsheet based processes. The governance process needs to provide management teams with comfort over the accuracy, robustness and completeness of the data submissions. But also management teams need the capability to understand the key drivers of the stress testing results in order to enable them to rapidly review, challenge and understand the outcome of the exercise.
What are the next steps?
The upcoming stress test is the latest in what will almost inevitably become a recurring exercise. Banks should therefore consider investing in the flexibility of their modelling capability for both credit risk (e.g. the impact from credit rating migration, default and lower collateral values) and market risk (e.g. full revaluation capability) to avoid the significant recurring time and resources cost of what has historically been a manual process.
Next year’s stress test will probably remind us that asset quality issues continue to leave banks exposed to a downturn. But perhaps the bigger question is how capable banks are to deal with this situation. If banks invest in integrated stress testing capabilities combined with a robust governance framework for their business as usual processes they can improve their strategic business planning. This would hopefully avoid the annual/bi-annual stress tests by authorities resulting in any major surprises for both management teams and investors.
The other positive outcome should be that banks are more transparent about their assets and their strategy around the need for any deleverage of bad assets. This would then potentially reduce the amount of capital being trapped by poor assets and reduce the overall lower capital requirements.
How much work does your organisation need to do to prepare for the 2016 stress test? To what extent do you think stress tests should be a recurring exercise? Will banks become more transparent as a result? Share your thoughts below or schedule a meeting to discuss your situation in confidence.