Can banks face turbulent times?
After the last financial crisis, many of us want to know how resilient the banking sector really is. Last week, the results of the latest European stress tests were announced. Every few years, the European Banking Authority (EBA) performs stress tests to “assess the resilience of financial institutions to adverse market developments.” The idea is to be able to compare and assess to what extent not just banks but the banking system as a whole could face future “shocks.” Let’s see how it’s done.
What do these tests consist of?
You may think of the stress tests as an exam that assesses a bank’s capabilities to face different macroeconomic scenarios. The EBA looks at the bank’s behaviour and the money it needs to continue functioning normally under certain stressful circumstances – hence the name “stress test.”
The exam was carried out based on the year-end 2015 figures of the banks. There are two scenarios – a baseline and an adverse scenario – and they cover the period from 2015 to 2018.This year, the adverse scenario, developed by the European Systemic Risk Board in Frankfurt, exposed banks to recessions in the EU in 2016 and 2017. The results of the exam give an indication of the banks’ capabilities to absorb losses and continue generating profit; in other words a clue as to how viable the tested banks are in this adverse economic scenario.
Once the banks receive the scenarios, they need to gauge the latters’ impact on their income, their credit and market risk positions, even their operational risk, over the three-year period in order to assess their solvency in these scenarios. Basically, they need to figure out if they could survive them. Of course, this is done following strict guidelines and under the watchful eye of the authorities.
Who is tested?
In its 2016 exercise, EBA tested 51 banking groups in Europe, which is considerably less than in 2014 (130 banks in 18 countries). As a reason, the organisation stated that it “decided to focus on a more homogeneous sample to ensure greater comparability.” The 51 selected banks held a minimum of EUR 30 billion in assets and represented around 70% of the national banking sector in the Eurozone in terms of assets. Smaller banks were to be tested separately by their local supervisors.
Though shorter than in previous years, the list of tested institutions was still quite exhaustive. Whether you are a Luxembourg resident or a cross-border commuter, you or your family are likely to bank with at least one of these groups: Belfius Banque S.A., BNP Paribas, Crédit Agricole Group, DekaBank Deutsche Girozentrale, Deutsche Bank AG, Commerzbank AG, KBC Group NV, ING Groep NV, etc. You can find the full list in the report of the EBA.
Can banks fail the test?
Yes, they can. In fact, this was the case for 24 banks (out of the 130 tested) in 2014. The “pass” mark required a minimum level of Common Equity Tier 1 capital (the highest quality capital). The financial buffers of these 24 banks were not sufficient to pass that mark. In the 2016 exercise, however, the EBA did not define any minimum hurdles as it did not expect capital requirements to rise in the three-year period between 2015 and 2018. Nevertheless, it still reported the results in terms of Common Equity Tier 1 (CET1), Tier 1 and total capital ratios, and this is what everybody is talking about. These results will be used by the authorities in the context of supervisory reviews and evaluation processes.
So now banks that scored well in CET1 can breathe a sigh of relief and focus on business as usual, maybe even growth. Banks that scored poorly will have some homework to do to improve their capital levels and follow the EU capital guidelines to ensure they can face turbulent times head-on.
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