Tougher European bank stress tests

In tougher European bank stress tests, banks will need to show that they can survive a 7% fall in gross domestic product (GDP), a 19% share price decline and a 14% drop in property prices, the European Banking Authority (EBA) announced.

A bank stress test determines how able a financial institution is to withstand an economic crisis through a simulation of events or an analysis. The tests evaluate whether there is enough capital in a bank to endure the impact of severe economic shocks.

The EBA explains that the tougher European bank stress tests are designed to prevent a repeat of bailouts of failing banks by the taxpayer, as occurred during the global financial crisis.

Andrea Enria chairperson of the EBA said:

“The methodology developed by the EBA for the stress test will ensure a robust and effective tool for supervisors to address remaining vulnerabilities in the EU banking sector.”

“The exercise’s full transparency will be key to its credibility: it will show how efforts recently undertaken by EU banks are already bearing fruit and it will provide a common framework for the next steps to be taken by supervisors and banks”.

New stress tests more realistic

Tougher European bank stress tests
Banks will need to show they can withstand a 7% drop in GDP, a 14% fall in house prices and a 19% decline in share prices.

The 2014 bank stress test is much more rigorous than the one devised by the EBA for 2011 when much milder hypothetical external shocks were presented, e.g. just a 0.5% fall in GDP.

The 2011 bank stress tests were criticized for not being strict enough, many economists pointed out that 18 of the European Union’s 27 member states were going through worse economic situations than the “worst case scenarios” of the hypothetical external shocks in the stress tests.

For the tougher European bank stress tests to be of any value, they need to present banks with scenarios that are at least as severe as those that occurred during the financial crisis and the Great Recession that followed.

What happens when a bank fails the stress test?

Banks that evidently do not have enough capital to endure the worst case scenarios will need to produce a plan to increase their reserves by selling assets, paying out smaller dividends from profits, or raising more funds from investors.

Banks in Europe have already implemented a range of reforms, including the accumulation of billions in capital ahead of the 2014 tests.

The tougher European bank stress tests will be conducted on a sample of 124 European Union banks which cover 50%+ of each national banking sector. They will be carried out with the cooperation of the European Central Bank (ECB) and the competent authorities at national level.

The EBA, in cooperation with the ECB, will be responsible for coordinating the exercise and making sure there is effective cooperation between home and host supervisors. “Most importantly, the EBA will act as a data hub for the extensive transparency of the results of the common exercise. On the other hand, CAs (competent authorities) will bear responsibility for overseeing the exercise with the banks, checking the quality of the results and identifying and implementing any necessary supervisory reaction measure,” the EBA wrote.

A PwC study found that banks do not have enough staff to deal with the regulatory stress tests. After carrying out a global survey of 24 banks, the researchers found that overall banks had underestimated the resources required to meet the demands of a tougher stress testing regime.

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