Bank stress tests – the post Covid agenda

In the early 1990s, stress tests became a popular internal tool for international banks to examine risks and gain a better understanding of threats to the institutions’ balance sheet. From there, the Basel Accord was amended in the mid- ’90s and required banks and investment firms to conduct stress tests. However, these were more internal exercises for the institution itself to improve risk management.

In the following years, a global economic slowdown caused massive disruption to the banking industry. As a result, the interest in banks stress test quickly came to the forefront of regulators minds. From 2011 the EU-wide stress test exercise aimed to improve banks’ ability to cope with financial downturns and to enhance transparency within the EU banking sector.

An EU-wide stress test was due to be undertaken this year. However, due to the outbreak of COVID-19, the EBA decided in March to postpone the exercise until 2021 to allow the banks to focus on core operations. Banks are facing a real-life stress test this year with uncertainty still surrounding the extent of the impact COVID-19 will have. Since 2008 EU banks have strived to build up a solid liquidity buffer, strengthen capital positions and improve the quality of assets held on their balance sheets. This current black swan event will certainly test the measures banks have taken.

It is yet to be seen whether the EBA will propose any changes to the templates that were released for the stress test due to occur this year. The EBA had already started the process of a public consultation on future changes to the EU-wide stress test (to be implemented post-2020 exercise); the consultation ran until the 30th of April 2020. José Manuel Campa, Chair of the EBA remarked at its launch, “The framework we are proposing today aims at making the EU-wide stress test more informative, flexible, and cost-effective. It is the first time we embark on a comprehensive discussion on the future of EU stress testing, and we are keen to receive feedback from a wide range of stakeholders.

The proposed changes are now aiming to allow a more flexible approach to the stress test for the exercise to be more beneficial to the banks themselves. There is a possibility of the introduction of a 2-leg approach:

  • The Supervisory Leg
  • The Bank Leg

The bottom-up approach currently in use would be the starting point for the supervisory leg. Competent authorities would also to adjust or replace banks estimates based on benchmarking tools.

The bank leg would allow for more discretion in the banks approach to calculating projections. They would have scope to relax the methodological constraints where it is possible to provide solid reasoning for use and any impact of these approaches. There have been two methods of disclosing results suggested:

  • Two separate outcomes:
    • The supervisory outcome would be directly linked to the bank’s Pillar 2 Guidance and would provide limited exposure. The bank leg would enable market discipline through its broader transparency with granular disclosure.
  • The single outcome approach
    • The single outcome would see the results combined; this would involve increased collaboration between supervisors and banks to collate the result appropriately. 

The single outcome approach has its benefits and drawbacks. While it would reduce the need for increased clarification of two separate results, it would involve a more hands-on approach from the supervisors concerning the bank leg. Increased interactions with competent authorities and banks may lead to a less cost-efficient exercise. The need for increased QA from supervisors would also lead to a diminishing effect on the flexibility of the bank leg.

When it comes to scenario design of the stress tests, the European Banking Authority (EBA) has requested feedback on the possibility of introducing exploratory scenarios, focusing on possible liquidity risks and Environmental, Social and Governance (ESG) risks.

The possible introduction of ESG scenarios is in line with the increased focus in 2020 of this topic. The EBA released their Action Plan on Sustainable Finance last December, within this, they have outlined an approach that starts with crucial metrics, strategies, risk management and moving towards scenario analysis and evidence for any adjustments to risk weights. The signal from European institutions is that sustainability is still at the forefront of their minds, and it will play a vital role in the economic recovery from the impacts of COVID-19.

In the first half of 2020, Mazars has analysed how 30 of the largest banks worldwide have been handling climate-related financial risks. One of the key takeaways from the report is that climate change is recognised as an aggravating factor of existing risks.

It’s apparent, the European authorities intend on changing the EU wide stress testing exercise to make it more beneficial to the banks, themselves and capture the risks banks may be vulnerable to from climate change and other sustainable finance issues. Climate change and ESG finance is a topic gaining traction even amid the global pandemic currently being faced, many see it as being crucial to the economic recovery. We expect the focus to continue along with increased dialogue between supervisors and banks on how to make the stress test exercise beneficial for everyone involved.

This article first appeared in the Finance Dublin Yearbook 2020 in August 2020.