Macro prudential stress testing: "Monitoring" the European financial system

By Riccardo Tedeschi | 25 October 2017

The most original innovations often stem from necessity or are born for the purposes of overcoming unforeseen difficulties. This is the case for macro prudential stress tests, namely a set of analysis techniques used by financial supervisory authorities since the great global financial crisis in 2007-2009. This approach has resulted in the achievement of significant advances in the grasp of the mechanisms governing the interactions between the financial system and the real economy on the one hand, and between the former and international relations on the other.

This article proposes to address three issues: when were stress tests introduced in Europe; what micro prudential stress tests are and what their purpose is; and what are their most recent developments. 

The introduction of stress tests in Europe

With the great financial crisis in 2007-2009, supervisory authorities worldwide unexpectedly realised that a number of banks, while well capitalised (that is to say, those banks whose assets and equity were aligned with the requirements set out by the very same supervisory authorities), were facing serious difficulties within a very short time due to losses accumulated on specific held assets (Asset Backed Securities, ABS) or on the grounds of liquidity. The numerous ensuing banking failures and the subsequent financial crisis are common knowledge. In Europe, the impact of the crisis further expanded with the so-called “sovereign debt crisis” that, between 2011 and 2012, affected countries of which the governments were most heavily indebted in relation to GDP.

The reasons and root causes, as well as the transmission channels of the great financial crisis will not be addressed herein.  The latter triggered a deep change in banking supervisory regulations on a global scale, with the transition from the so-called Basel II agreements that had just come into force in 2007(lthough finalised since 2004, the Basel II agreements became active only in January 2007), to the subsequent Basel III agreements in 2010, reinforcing the capital requirements of banks and introducing a wealth of restrictions and controls relating to their degree of liquidity.

Since 2009, the supervisory authorities of various countries, such as the USA, Great Britain and the European Central Bank in the Euro area, started to internally conduct a series of stress tests on the monitored banks following a top-down approach, in order to better orient their monetary policy and supervisory decisions.

In 2014, prior to the launching of the Single Supervisory Mechanism (SSM) and upon the initiative of the European Banking Authority (EBA) in collaboration with the ECB, an extensive and accurate analysis of the assets held by the 130 main European banks to be monitored by the Frankfurt authorities was conducted (comprehensive assessment). This analysis also included a stress test at the level of each individual bank with a bottom-up approach. The EBA EU-wide stress tests, that is to say extended to larger European banks (significant institutions) were then replicated in 2016 and will be repeated every two years.  The next will be conducted in 2018.

At the end of 2014, the entire Supervisory Review and Evaluation Process (SREP) was reformed. This is the annual process in which supervisory authorities assess the situation of each individual bank: the business model, the governance of equity risks and liquidity risk. Stress tests therefore became part of the instruments used for the risk assessment of individual banks on a permanent basis.

Stress tests and reverse stress tests were also introduced within the context of the “recovery plans” under the new European legislation on banking resolution (BRRD).

It is no exaggeration to say that today, ten years after the onset of the Great Crisis, all risk managers within medium-large banks carry out at least one stress test per year for management and regulatory purposes.

Microprudential testing by the EBA

The purpose of micro prudential testing for any bank may be explained by drawing the following parallel example. Just as athletes taking part in sporting competitions are required to undergo ECG monitoring on a regular basis to detect any potential cardiovascular anomalies arising only upon exertion (that, conversely, would not emerge at rest), banks aiming to compete in financial intermediation must undergo tests to appraise their resistance to periods of prolonged recession in particularly adverse scenarios.

When a bank fails to adequately pass stress tests, the supervisory authorities may take action by imposing measures of increasing intensity, such as organisational or strategy changes, an increase in liquidity buffers, the suspension of payment of dividends or an increase in capital.

The EU-wide stress tests organised by the EBA are mandatory for the larger banks monitored by the ECB and consist of simulations conducted at the level of each individual bank, with the primary aim of evaluating their financial soundness.

In brief, the characteristics of the EBA stress tests are clarified as follows:

A dedicated European Systemic Risk Board (ESRB), which relies on data and resources provided by the ECB, develops two macro-financial scenarios identical for all banks: a baseline scenario expressing the consensus forecasts and an adverse scenario representing the rather unlikely, albeit not unrealistic, negative evolution of the economic and financial situation. These scenarios are delivered to all participating banks.

The banks undergoing stress testing should simulate the evolution of their budgetary developments over a three-year time horizon: capital situation and income statement; regulatory capital and the so-called Risk Exposure Amounts, REA, also referred to as Risk Weighted Assets, RWA. There is a special focus on solvency indicators: CET1 capital ratio, which is the ratio between the best liable equity capital (the Common Equity Tier 1, CET1) and the RWA. For the test to be successful, this ratio at the end of the simulation horizon must be above a specific threshold. In the first stress-testing edition in 2014, the CET1 capital ratio thresholds were respectively equal to 8% for the baseline scenario and 5.5% for the adverse scenario. Banks falling below one of the thresholds were required to submit an action plan for the recapitalisation of the business. By contrast, in the second stress-testing edition in 2016, the EBA did not make the thresholds explicit, even if the substance of the test remained unaltered.

Figure 1 illustrates the aggregated results of the 2016 EBA stress tests: the evolution of the aggregated CET1 capital ratio percentage that, from an initial 13.2% in 2015, drops to 9.4% at the end of 2018: a 380-basis-point negative impact within the European average. 

Figure 1- Evolution of the aggregated CET1 capital ratio % and impact (bps) in relation to the initial figure in 2015 (bps)

Source: EBA, ST 2016 Results

Instead, Figure 2 illustrates the impacts of stress testing on the CET1 capital ratio over the three years of simulation between 2015 and 2018 in the adverse scenario per individual bank (the impacts are detailed in the two scenarios, “phased-in” or “transitional” CET1 capital ratio, calculated on the basis of a gradual transition provided for by the Basel III regulations until 2018, and “fully loaded” CET1 capital ratio, namely according to the comprehensive regulations in force after 2018). As shown, there is a great diversity of results across the different banks.

Figure 2 - Impact on the CET1 capital ratio between 2015 and 2018 in the adverse scenario per individual bank

Source: EBA, ST 2016 Results

In its present configuration stress-testing, while based on macro scenarios developed by the ESRB, is conducted according to a “microeconomic” approach.  The calculations are made by each individual bank and, as mentioned, follow a bottom-up basis: banks use their own management systems and usually summarise the data of their managed portfolios from a very granular database at the level of each individual operation.

The preliminary results processed by the banks are then forwarded to the supervisory authorities and are subject to a careful “quality assurance” process, with a “traffic-light” returned report system: “green light”: go-ahead; “yellow light”: request for further clarifications and information; “red light”: blocked and returned to sender for new processing. In order to formulate their own opinions and identify any potential abnormalities, the supervisory authorities rely on different systems. The most important is an actual top-down budget simulation model of the individual bank, that uses aggregated budget data and the reports received for monitoring purposes and a sophisticated benchmarking system, comparing the performance of similar size and with similar business models.

The main characteristic of the EBA EU-wide stress tests is that they are based on the so-called ‘static balance sheet’ approach: in the course of the three-year simulation period, any variation in the volumes of the masses managed are considered in relation to those at the start of the period. In other words, no bank can grow with new loans to customers, deposits or bonds issued to customers, or an increase in the volume of managed savings, even indirectly (assets under management). As the lending and funding transactions expire, they are reinvested in the same type of original transactions. This scenario aims to equate all banks taking part in the stress testing (playfield levelling), irrespective of the differences in growth provided for by the strategic plans of the individual businesses.

The sole budget item that is allowed to grow during the simulation is the one relative to non-performing loans, that shift their status from performing loans to defaulted on the basis of the probability of default as estimated by the bank and that then determine the value adjustments on loans, according to the estimated loss rates (Loss Given Default, LGD). The probability of default and the LGD are estimated by the individual banks via own “satellite models”, based on the economic scenarios provided by the ECB and especially in the adverse scenario can reach very high levels as compared to the current ones.

The “rules of the game” of such testing include some particularly stringent ones for commercial banks. First, the bank cannot recover any amount on assets in a state of insolvency (no workouts on defaulted assets): this circumstance is all the more burdensome the greater the value of the non-performing loans (typically, in the real world, banks recover a significant portion (on average 40%) of the defaulting loans over a number of years - for Europe, on average three years, for Italy five years). During the simulation, a deteriorated credit rating of the bank is also hypothesised, to generate an increase in the cost of borrowing of the bank itself that cannot be recovered via an increase in the rates for loans to customers and the ensuing compression of the interest margin of the bank (the compression of the interest margin is all the more intense the lower the initial rating of the bank itself).

The stress testing part concerning the liquidity risk is, on balance, relatively limited. However, a strong negative impact is taken into account on the value of Government securities and other securities in the portfolios of financial assets held for sale and negotiation purposes (recently, some authors have raised the issue about how to render stress tests more accurate and in a way more “severe” owing to the market risks embedded in the so-called “level 3 assets”, namely the unlisted securities that are evaluated according to bank's internal models).

In part two of this article, which will be published next week, we will take a closer look at macro prudential test testing carried out by the ECB.