The global financial crisis and the aftermath that continues to unfold have created a justifiable obsession with stress among bankers and supervisors: how to prepare for it, guard against it and respond when it flares up by understanding the various sources of risk to which each institution is exposed and how the exposures interact with one another. The sharper focus has made stress testing a key component of the evolving global regulatory framework covering risk control, capital discipline and reporting.
The latest round of European tests, in 2014, comprised 124 banks, compared to 91 in 2011, and the banks tested last year were not the only ones affected. Small- and mediumsized
institutions do not undergo stress testing per se, but national regulators have imposed ancillary requirements, seeking qualitative and quantitative information on certain aspects of their business related to risk mitigation under various scenarios.
The 2014 test examined two scenarios – baseline and adverse – using a three-year horizon instead of two, as in 2011, implying a more dire financial or economic crisis under the adverse scenario and extremely high risk aversion. The tested banks fared well collectively. From a weighted average Tier 1 common capital ratio of 11.1 percent of assets at the end of 2013, participating banks would lose 261 billion euros under the adverse scenario, mostly from credit losses, taking the capital ratio to 8.5 percent. Fourteen banks failed the test under the baseline scenario, defined as an inability to maintain a capital ratio above 8 percent, and 24 failed to maintain a ratio above the 5.5 percent benchmark established for the adverse scenario.
A more dynamic approach
The EBA and ECB want to conduct stress testing at least once a year, with banks required to submit more exhaustive information than in the past. That would raise the cost of compliance, of course, and complaints from institutions persuaded regulators to postpone the next tests until 2016. Testing is expected to change qualitatively, too. The clear inadequacies of static assessment make it likely that supervisors will shift toward methods with a greater behavioral component and an emphasis on feedback mechanisms that lead to continual revisions of models as bankers adjust to fluid events on the ground. That would better reflect a commonsense understanding of reality during crises and would conform to test procedures in other jurisdictions, notably the United States
Future ECB stress scenarios may require institutions to assess a wider array of exposures, perhaps delving into liquidity risk under different funding structures. The 2011 tests focused on credit and market risk, while the 2014 exercise added sovereign risk into the mix. It downplayed the prospect of sovereign default, however, a decision that regulators might have reconsidered if they had suspected that events would play out as they have in recent months.
Part of a greater whole
Stress testing in Europe is not intended as a standalone exercise but as an integral component of the capital-planning process that permeates the procedures for measuring, analyzing and managing risk. Stress testing is a primary feature of ILAAP/ICAAP, or the Internal Liquidity Adequacy and Internal Capital Adequacy assessment processes. These are standards under Basel III, applying to all institutions, and are used to measure and monitor liquidity and determine capital needs, respectively, based on various risk factors. Other rules mandate stress testing in such areas as proprietary trading and data management, with sufficient flexibility to produce forward-looking risk analytics in a user-friendly form for regulators and bank officials, and also to devise a detailed recovery plan for a severe stress scenario.
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