Stress Testing

A Test That Can’t Be Failed?

Nouy-DPA
Back in the spotlight: The ECB's top supervisor, Daniele Nouy, will help the EBA with its stress tests.
  • Why it matters

    Why it matters

    The new round of stress tests is facing questions about its credibility as it will use different criteria to previous tests.

  • Facts

    Facts

    • The stress tests will cover 70 percent of the total balance sheet of banks in the European Union.
    • Financial institutions failing the test can be required to increase their capital reserves.
    • The Bank of England is testing English banks with results to be announced in December.
  • Audio

    Audio

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On the surface, it appears none of the participants in the next round of European-wide bank stress tests will make fools of themselves.

The continent’s top regulators – the European Banking Authority and European Central Bank – will put 53 financial institutions in the European Union through their paces early next year, inspecting their balance sheets for risks and asking whether they really have the tools needed to withstand a future financial crisis.

It will mark the first pan-European test since 2014, when the EBA and ECB tested about twice as many banks in Europe in a much bigger – and novel – exercise.

But as the EBA announced Thursday, in contrast to past tests, this time banks won’t be judged on whether their reserves can hold up in times of serious stress – a financial crisis, for example. There will not be a minimum threshold banks have to pass. In other words, they can’t really fail.

There will not be a minimum threshold banks have to pass. In other words, they can't really fail.

Instead, the EBA said its new format will focus on evaluating exactly how banks would fare in a crisis, rather than giving a hard pass/fail grade. The idea is to better assess their business models and risks of the banks and, therefore, their resilience if the financial sector should suffer another massive downturn. The test is also designed to provide regulators across Europe with a consistent base to compare and assess the adaptability of banks in the face of potential shocks.

That doesn’t mean there won’t be consequences. The results will feed into the annual reviews of the E.U.’s national and pan-European supervisors, which since the 2008 crisis have had more power to require financial institutions that fare poorly in the tests to beef up their capital reserves.

Nicolas Veron, a senior fellow with the Brussels-based Bruegel and Washington-based Peterson Institute for International Economics, said the lack of a pass/fail grade “doesn’t change much about the nature of the exercise.” The big question, Mr. Veron argued, is exactly how much information will be released to the public and how much will be kept between the supervisors and their banks.

The EBA is working closely with the European Central Bank, which has been responsible for banking supervision in the 19 European countries that make up the euro zone since November of last year. The ECB, which keeps watch over more than 100 banks in the euro zone, in its own statement Thursday said it would use the results “to assess Pillar 2 capital needs of individual banks” as part of its annual review of each bank’s health.

The 10 participating German banks include Deutsche Bank, Commerzbank, DZ Bank and the state banks BayernLB, LBBW, Helaba and NordLB. In 2014, 20 German banks were part of the test. While none of them were required to boost their capital reserves, the test still highlighted a number of risks in the German banking system, which has more banks competing against each other than any other country in Europe.

Altogether, the stress tests will cover 70 percent of the total balance sheet of banks in the European Union. Additional details on methods are scheduled to become public in February. Results are expected in the third quarter of 2016.

Authorities last tested European banks in 2014, probing about 130 financial institutions, of which 25 failed because they were unable to demonstrate that their capital ratio – a measure of their reserves against their lending – would remain above 5.5 percent in a crisis.

While the EBA has conducted repeated tests of Europe’s banks since the 2008 financial crisis, the 2014 test marked the first time the European Central Bank, which took over supervising the largest banks in Europe, was involved in testing. The central bank’s involvement gave it some added credibility among bank watchers, though some of the reviews were still mixed.

While the first stress test marked the central bank’s first foray into examining bank balance sheets – and was done largely with the help of national supervisors – the new round next year will be the first that is led more fully by the ECB and its new team of banking supervisors.

The ECB and other regulators have been busy over the past year steadying banks by demanding they hold more capital. But while regulatory authorities worldwide have increased requirements for banks’ capital buffers, this hasn’t eliminated some people’s concerns about their ability to withstand shocks.

The biggest criticism from 2014 was that the supervisors’ worst-case scenario wasn’t really all that bad. The key question for bank watchers this time around is: Will the ECB and EBA get tougher on what constitutes a crisis? Details will only be released in February.

Mr. Veron, however, said the credibility of the ECB as a supervisor has increased since it started in November 2014, partly because there haven’t been any spectacular bank failures since it took over. While he expects next year’s stress test might still be a little rough around the edges, he said the ECB should become more routine by 2017 or 2018.

“Next year’s stress test will be both more integrated in the genuine [supervision] process than last year and also less of a headline grabbing thing,” Mr. Veron told Handelsblatt Global Edition. “This is a huge transformation and I don’t think this transition will be over by the first half of next year.”

Ahead of the next EBA stress test, the Bank of England will also test British banks to assess their ability to withstand crises. In this test, global risks will be given more weight than threats stemming from the domestic economy. Among other things, the scenario will include a decline of Chinese economic growth and liquidity shortfalls in emerging economies. The results will be published in December.

Nor will this be the only examination of banks to be conducted by European supervisors. The ECB said it would conduct its own testing “in parallel” of smaller financial firms that are not covered by this round.

The ECB itself also conducted a separate stress test of Greece’s beleaguered banks. Following that review, the central bank has demanded Greek banks raise a total of €14.4 billion in fresh capital. The banks had until Friday to respond with how they planned to raise the money.

 

Katharina Slodzcyk is Handelsblatt’s financial correspondent in London. Christopher Cermak is an editor covering finance for Handelsblatt Global Edition in Berlin. To contact the authors: slodczyk@handelsblatt.com and cermak@handelsblatt.com

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