On February 24th 2016 the EBA launched its fifth EU-wide stress test, an exercise designed to test a bank’s resilience against an adverse financial scenario. Institutes will use 2015’s year-end figures to assess the impact of a hypothetical crisis over a three-year period following the guidelines of the EBA common methodology. Participating banks have had the chance to discuss the requirements since the documentation was released in November 2015, and they have been supported whilst preparing for the exercise.
For the EBA’s previous stress test, the CRD IV Tier 1 ratios were used as the main assessment criteria; a 5.5% hurdle rate for the adverse scenario and 8.0% for the baseline. 123 banks took part in the 2014 exercise, which tested their solvency against hypothetical strains on the EU economy such as a cumulative deviation on EU GDP. A total of 24 banks across Italy, Greece, Belgium and Slovenia failed to meet the criteria of the scenario, giving them nine months to make improvements and raise capital to avoid being shut down.
The results of the 2014 exercise had an immediate effect on the EU banking industry. Shares in Lloyds dropped over 2% after they narrowly passed the exercise, whilst shares for some failing banks fell by almost 18%. Despite a narrow pass from Lloyds, all UK banks passed the 2014 stress test leading to a 50 point rise in the FTSE 100, as investors were reassured that the banks were able to sustain themselves through an economic crisis. The EBA’s report is extensive and makes it clear which banks in the EU are the most resilient; for institutions with a high pass rate, shares increased immediately, such as Austria’s Raiffeisen which saw a 7.3% raise.
In both 2014 and 2016’s test, the adverse scenario includes a dramatic shift in real estate rates (both commercial and residential) and a shock to the foreign exchange rates in Central and Eastern Europe. Growing confidence in the EU job market is apparent in the EBA’s test, as the 2014 scenario took into account a hypothetical rise in the unemployment rate which has not been included in this year’s exercise.
With the adverse scenarios, the EBA also releases what they consider to be the biggest threats to the financial stability of the EU. One of 2014’s potential threats regarded public perception of the banking industry, theorising that ‘stalling policy reforms [would jeopardise] confidence in the sustainability of public finances’. With the COREP regulations receiving a wealth of taxonomy updates in 2015, it will be interesting to see what impact - if any - this year’s public perception scenario (‘rising of debit sustainability concerns in the public and non-financial private sectors’) has on the CRD IV reporting requirements.
A few changes have been introduced for this year’s exercise. For one there is no ‘pass or fail’ status awarded at the end of the stress test. Instead the focus will be on the results of each individual bank taking part, and what their figures mean for their business model. Less than half the number of banks are participating this year, with only 51 taking part in the exercise compared to 2014’s 123. This year’s test will also have more of a focus on conduct risk rather than funding and market risks, and competent authorities will work with the banks to ensure that the stress test is compliant and secure.
Whilst there’s likely to be a lot of coverage and predictions around this year’s stress test, the results will not be published until Q3 this year. Following the exercise, the EBA will carry out a Supervisory Review and Evaluation Process (SREP) to explore the results in more detail. As well as informing banks of any immediate capital concerns that are flagged from the test, the results will provide an overall assessment of the stability and resilience of banks across the EU.
With all eyes on this summer’s Brexit referendum, the four UK banks participating (HSBC, Barclays, RBS and Lloyds) will find themselves under more scrutiny than in previous years. The bigger challenge will be the UK stress test set by the PRA (which Lloyds and RBS narrowly passed by 0.1% and 0.5% of the minimum capital ratio required respectively in 2014), which are arguably even more challenging than the EBA’s exercise. The SREP will be released just weeks after the referendum, and any UK banks failing to meet the hurdle base line margins set by the EBA will find themselves under strong criticism, regardless of the Yes/No result.
By Andy Gent, Director, Arkk Solutions.