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All eyes on ECB’s stress test results: More questions than answers?

Anticipation is rising ahead of the results of the latest ECB stress tests on European banks, due on 29 July. The results will determine whether the banks have sufficient capital buffers to withstand theoretical adverse swings in asset prices, interest rates and other macro-economic variables. But, are these eagerly-awaited results going to produce more questions than answers?

Although this is the most comprehensive of these industry-wide assessments to be conducted by the ECB, some are still questioning whether the regulator is using the right criteria to assess bank vulnerability. Either way, what is certain is that in the new ecosystem envisaged by the ECB going forward banks will not only need smarter data management practises in place to be able to manage risk and allocate capital better – but also must be able to demonstrate it.

The ECB has also raised eyebrows by making it clear that its stress tests of the 51 banks selected (comprising around 70% of the EU’s banking sector) will not be making any pass/fail judgement of individual banks. The exercise is rather designed to “be used as a crucial input into the SREP (Supervisory Review & Evaluation Process) analysis for 2016.”

At its heart these stress tests are designed to “assess banks’ ability to meet applicable minimum, and any additional, capital requirements under stressed conditions”, according to the European Banking Association, which is co-ordinating the exercise. The revised approach is also placing a greater emphasis on quality, with an expected higher stressed dilution of capital.

Much has been written recently about perceived capital shortfalls across European banks, particularly in Italy where non-performing loans are having an insidious effect. Investors will therefore be looking for some reassurance that the authorities will at least be using this exercise to restore some confidence in the sector.

The review encompasses the few EU banks deemed globally systemically important (G-SIBs), as well as tier 1 local and regional banks. These include 39 banks under the Single Supervisory Mechanism (SSM) and 12 others. But it should be said that these banks already tend to have both higher capital ratios and lower levels of non-performing loans than smaller counterparts. The tests were performed during March to May, with quality assurance tests conducted from May to July.

The principal areas of focus were around credit and market risk, with an assessment of entire banking books by asset class, as well as all financial assets and liabilities. For the first time there will also be an analysis of the impact on bank P&Ls with regards to conduct and other operational risks. The end result is intended to be a methodology to identify and integrate a regulatory capital management framework with the stress tests, similar to that introduced by the Bank of England a year ago.

This would include Pillar 1 and 2 base levels (up to 5.5%), and the G-SIB Buffer (a further 2.5%) up to the minimum required tier 1 capital of 8%. In addition, there should be a Conservation Buffer of a further 2.5%, a Counter-cyclical Buffer of another 1.5% and lastly a PRA Buffer of 1% for a potential total of 13%. If stress test losses go below the Pillar 1 & 2 levels capital actions will be required. It all adds up to a lot of money tied up in unproductive assets.

Banks will certainly be safer, but they will struggle to generate profits, particularly in the current interest rate environment. This is, however, the road regulators have chosen to pursue. But some are already questioning the process and methodology that has been adopted, which is seen as a top-down approach that only analyses the impact of market and macro-economic changes on a bank’s capital ratios. Far more effective, argue some analysts, would be to employ the SRISK methods developed by professors at the NYU Stern School of Business and the University of Louvain-la-Neuve.

This SRISK approach challenges a bank to re-calculate how much more capital it would need to raise to maintain capital ratios during stressed economic conditions and what it would cost to do it. This, they believe, is more important to know than just how much capital ratios would fall. After all, if those ratios drop the banks will be required to start repairing balance sheets during the economic turbulence, not just allowed to wait for normal market conditions to be restored.

Under this methodology, the impact on many bank balance sheets produces considerably greater dents than the ECB’s adverse scenario approach due to the need to include forced asset sales, or capital dilutions from the prices potentially paid to raise it, during abnormal markets. In many instances the impact is a factor of two to four times greater than that produced by the current stress tests.

However, moving forward, banks will be steadily expected to take on more regulatory obligations that will, in effect, see them being forced to build these type of stress tests into their day-to-day business models. In particular the advent of FRTB (Fundamental Review of the Trading Book) under which banks will have to be able to demonstrate compliance during 2019 ahead of the 1 January, 2020 deadline. It effectively forces banks to test potential trades and actions prior to their execution to demonstrate any potential impact on P&L and balance sheet in adverse market conditions.

This will require the adoption and integration of more sophisticated data management and analytic capabilities to be able to show regulators that these risks are being understood. In fact, even the current ECB stress tests will be seeking to identify areas in banks where the quality of stress testing practises are poor. Both aspects mean banks will have to seriously consider the strategic implementation of technology that delivers visibility both within asset classes, as well as across the enterprise, and, most importantly using consistent data sets in as close to real-time as is feasible.

They are challenges that should not be underestimated, whatever the results of the latest ECB exercises. The message is getting clearer and louder from regulators. They want banks to deliver more transparency, more risk awareness and more confidence in bank decision-making – and any ramifications that may result. It is not something that can be pushed into the long grass any longer.

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