Frequently asked questions on the 2018 EU-wide stress test

2 November 2018

Stress Test FAQ

What was the purpose of the 2018 EU-wide stress test?

The EU-wide stress test analysed how banks’ capital positions developed under both a baseline and an adverse scenario on the basis of data from year-end 2017 over the three years to year-end 2020.

The exercise has provided supervisors, banks and other market participants with a common analytical framework to compare and assess the resilience of EU banks to country-specific economic shocks.

The stress test included 48 banks, representing 70% of total banking assets in the European Union. The European Banking Authority (EBA) had overall responsibility for the exercise – it developed the methodology, decided on the scenarios and any one-off adjustments, and published the stress test results at the end of the exercise.

As in 2016, the stress test was not a “pass or fail” exercise. No hurdle rates were set to define the failure or success of banks for the purpose of the exercise. The findings of the stress test will be part of the ongoing supervisory dialogue. As such, the supervisory arm of the European Central Bank (ECB) will use both the qualitative results (quality and timeliness of banks’ submissions) and the quantitative results (capital depletion and banks’ resilience to adverse market conditions) as input to the Supervisory Review and Evaluation Process (SREP). In the context of the SREP, the stress test results will also be used as input when determining the supervisory capital demand on banks.

Which of the banks supervised by the ECB took part in the EBA’s EU-wide stress test?

Of the 48 banks covered by the EBA-led stress test, 33 are directly supervised by ECB Banking Supervision, covering 70% of banking assets in the euro area. Individual results for all 48 banks, along with detailed balance sheet and exposure data as of year-end 2017, were published by the EBA on Friday, 2 November 2018.

In addition to the 33 ECB banks in the EBA sample, the ECB conducted its own stress test (SREP stress test) in parallel for those banks it directly supervises but which are not included in the EBA sample.

Earlier this year the ECB also tested the four Greek banks it directly supervises. While following the same methodology and approach as the EU-wide stress test run by the EBA, it applied an accelerated timetable in order to complete the test before the end of the European Stability Mechanism’s third support programme for Greece.

What is the overall outcome of the 2018 stress test? What were its main drivers and how do they compare with the 2016 stress test?

The adverse scenario results in a total CET1 depletion for the 33 banks under direct ECB supervision of 3.8 percentage points on a fully loaded basis, reducing system-wide CET1 capital from 13.7% at year-end 2017 to 9.9% at year-end 2020. This includes a 0.3 percentage point impact from the first-time application of International Financial Reporting Standard 9 (IFRS 9), which came into force on 1 January 2018. The corresponding depletion is 0.5 percentage point higher than in the 2016 exercise.

One key driver of the results under the adverse macroeconomic scenario was credit impairments. A second was a funding spread shock that was partly offset by the positive effect of higher long-term interest rates. A third was significant stress to net fee and commission income and a fourth was the impact of market price and liquidity shocks on fair value portfolios.

The outcome under the adverse scenario reflects a more severe macroeconomic scenario and the introduction of IFRS 9. It also reflects a more risk-sensitive methodology. This over-compensates for the effects of improved asset quality, especially as a result of the successful reduction of volumes of non-performing loans (NPLs) and the benefits arising from the steeper increase in long-term interest rates under the scenario.

Despite the higher depletion, the aggregate post-stress capital ratio of 9.9% for CET1 is higher than that recorded in 2016, when it was 8.8%. This confirms participating banks’ improved resilience to macroeconomic shocks. However, the exercise also exposed vulnerabilities in individual banks, which supervisors will follow up on.

The adverse scenario results in a leverage ratio depletion for the 33 banks under direct ECB supervision of 0.98 percentage points on a fully loaded basis, reducing the leverage ratio from an average 5.11% at year-end 2017 to an average 4.13% at year-end 2020.

Do you expect capital demand in the system to increase on average as a result of the stress test exercise?

We do not expect capital demand to increase on average as a result of the test. There are, nonetheless, developments in some of the components that mechanically increase the capital demand. However, this was expected and is independent from the stress test. These include components of capital demand that will continue to be phased in and reach their fully loaded value on 1 January 2019, such as the systemic buffers set by macroprudential authorities (buffers applicable to global and other systemically important institutions and systemic risk buffers). As stated in the SREP Booklet 2016 and 2017, banks should also expect to have positive P2G in the future, irrespective of the phasing in of the capital conservation buffers.

How will the stress test results be factored into the SREP?

The qualitative outcome of the stress test will be included in the determination of the Pillar 2 requirement (P2R), especially in the risk governance element of the SREP.

The quantitative results, namely the depletion of capital in the hypothetical adverse scenario, serve as a starting point for determining the level of Pillar 2 guidance (P2G). In defining P2G, the ECB will use a wide range of information. One benchmark will be a bank’s post-adverse scenario result in relation to a capital ratio of 5.5% or, in the case of global systemically important banks (G-SIBs), 5.5% plus the G-SIB buffer.

This result will be further adjusted up or down, taking other factors into account. These include the specific risk profile of the individual institution and its sensitivity to the stress scenarios; interim changes in its risk profile after the stress test cut-off date (31 December 2017); and measures taken by the bank to mitigate risk sensitivities, such as asset sales. As a result, the stress test results will feed into P2G in a non-mechanistic way.

It is therefore not possible to calculate the P2G for any institution by following a mechanistic approach and without knowledge of these other factors.

What are the key takeaways from this year’s stress test?

Credit losses can mostly be explained by the macroeconomic scenario. NPL stocks played a less prominent role in the exercise in 2018 than in 2016 as a result of improvements in banks’ balance sheets.

Under the adverse scenario the impact of the full revaluation in market risk was strongest in G-SIBs. However, on the upside it resulted in higher client revenues. The stress impact on model uncertainty and liquidity reserves also affected these banks more than others.

Adjustments to dividends, coupon payments on Additional Tier 1 instruments and variable compensation (maximum distributable amount) under Article 141 of the Capital Requirements Directive in reaction to a crisis would reduce the overall impact under the adverse scenario by approximately 40 basis points.

The stress test provides important additional insights into banks’ stress testing and risk management capabilities. Together with the assessment of the quality and timeliness of banks’ submissions during the exercise, this information will feed into the SREP and the determination of P2R and the planning of on-site inspections and other supervisory activities.

The test also allows us to verify whether banks have successfully addressed weaknesses identified in past exercises, for example with respect to stress testing, data aggregation or modelling capabilities.

What exactly did this exercise test and what were the key differences compared with the 2016 stress test?

The exercise assessed banks’ resilience to adverse market developments. It did so by analysing how their capital position developed, assuming a static balance sheet over the three years from end-2017 to end-2020 under both a baseline and an adverse scenario. The baseline scenario was in line with the December forecast published by the ECB, while the adverse scenario assumed the materialisation of four systemic risks which were deemed to represent the most material threats to the stability of the EU banking sector. These risks were:

  1. an abrupt and sizeable repricing of risk premia in global financial markets
  2. an adverse feedback loop between weak bank profitability and low nominal growth resulting from the decline in economic activity in the EU
  3. public and private debt sustainability concerns in the context of a potential repricing of risk premia and increased political uncertainty
  4. liquidity risks in the non-bank financial sector, with potential spillover effects on the broader financial system

The stress test assessed the impact of risk drivers on the solvency of banks. Banks were required to stress a common set of risks (credit risk, including securitisations; market risk and counterparty credit risk; and operational risk, including conduct risk). In addition, they were required to project the effect of the scenarios on net interest income and to stress profit and loss and capital items not covered by other risk types.

For those banks applying IFRS, the stress test projections took into account the introduction of IFRS 9 on 1 January 2018. They also took into account the provisions in Regulation (EU) 2017/2395 regarding the transitional arrangements for mitigating the impact of the introduction of IFRS 9. The transparency templates published by the EBA also include the impact of the first-time adoption of IFRS 9.

How was the ECB involved in preparing the stress test?

The ECB supported the preparation of the EU-wide stress test by contributing to the development of the EBA methodology and providing the baseline scenario.

This scenario reflected macroeconomic developments under normal conditions, taking into account the projections produced by the Eurosystem, the International Monetary Fund (IMF) and the Organisation for Economic Co-operation and Development.

In addition, the ECB contributed, under the overall coordination of the European Systemic Risk Board, to the design of the adverse scenario for the stress test.

What is the ECB’s role in the running of the EBA-led stress tests?

Within the overall framework of the EU-wide stress tests coordinated by the EBA, the ECB is responsible for the quality assurance process for the banks under its direct supervision. The key objective of this task, which is carried out jointly by the ECB and the national competent authorities, is to ensure that banks apply the common methodology developed by the EBA correctly.

In addition to the EU-wide exercise, ECB Banking Supervision conducts the SREP stress test for those banks under its direct supervision which are not in the EBA sample. This stress test uses a methodology that is consistent with the EBA methodology but gives due consideration to the smaller size and lower complexity of the participating institutions.

How does the ECB ensure proportionality in the stress tests?

Proportionality is already embedded in the EBA methodology and templates. This is reflected in the fact that smaller and less complex banks can apply less sophisticated approaches and are required to report fewer data points.

In the SREP stress test, ECB Banking Supervision extends the principle of proportionality for smaller and less complex banks by applying less sophisticated approaches and less strict reporting thresholds.

What were the key characteristics of the adverse scenario used for the 2018 stress test and how realistic was it?

The adverse scenario for the 2018 stress test was based on consistent and severe macroeconomic conditions. These included a euro-area wide contraction of 2.4% in gross domestic product (GDP), real estate price shocks of 17% and an equity price reduction of 31%.

The scenario reflected the main systemic risks identified at the beginning of the exercise. These included: abrupt and sizeable repricing of risk premia in global financial markets; adverse feedback loop between weak bank profitability and low nominal growth; public and private debt sustainability concerns; and liquidity risks in the non-bank financial sector with potential spillover effects on the broader financial system.

As regards plausibility, adverse macroeconomic scenarios for stress testing should be severe but plausible in order to ensure that the stress test results are credible.

The calibration of the EBA scenario was based on the main financial stability risks deemed relevant at the launch of the stress test. The scenario reflected a plausible configuration of events, although such a constellation of negative shocks would be rare.

For example, for most countries the main components of the macroeconomic scenario in the 2018 stress test were more severe than in the 2016 exercise. A deep global macroeconomic crisis was assumed, lasting for two to three years. The scenario modelled a global shock that affected European economies in different ways. The results should therefore be interpreted as being driven by a mixture of country risk and idiosyncratic bank risk.

The scenario for 2018 had to be developed earlier than in 2016. This was because the stress test was conducted earlier for Greek banks than for other banks and the main exercise lasted longer as a result of the introduction of IFRS 9. That said, the scenario was sufficiently wide-ranging to cover a number of contingencies. This is especially true as, by design, a scenario is not an exercise in prediction but a “what if” process meant to uncover vulnerabilities which are relevant when assessing banks, even though the underlying risks might materialise in different ways.

How does the 2018 stress test compare with stress tests in other jurisdictions?

Notwithstanding a number of methodological differences in the frameworks of the various stress tests, the overall results of the EBA-led test are broadly comparable with those of recent exercises in other jurisdictions.

For example, if we compare the EBA 2018 adverse scenario with that of the U.S. Federal Reserve’s Comprehensive Capital Analysis and Review (CCAR) 2018, the severity of the EBA scenario for the domestic economy lies between the CCAR’s adverse and severely adverse scenarios. The severity of the EBA 2018 adverse scenario for the domestic economy is comparable with that of the Bank of England’s annual cyclical scenario 2018. It is also comparable with the euro area Financial Sector Assessment Program stress test published by the IMF in July 2018.

Did the stress test account for the potential impact of the outcome of the United Kingdom’s referendum on EU membership? Were the consequences of a “no deal” scenario considered?

Elements of the baseline scenario reflected the average of a range of possible Brexit outcomes for the United Kingdom’s trade relationship with the EU.

The adverse scenario applied was significantly harsher than analysts’ forecasts of the negative impact of Brexit on the economy of the euro area. No one-off event, such as Brexit, was assumed. However, the projections for the euro area’s GDP under the adverse scenario were more severe for every year of the stress test horizon than the negative effect of Brexit on GDP growth as forecast by analysts.

The adverse scenario encompassed a wide range of macroeconomic risks that might be associated with Brexit. One of the key drivers of the adverse scenario was related to political uncertainty (including Brexit-related developments). This uncertainty was assumed, among other things, to trigger adverse confidence shocks in developed economies at the beginning of the projection horizon.

The consequences of a “no deal” scenario were not explicitly considered but the potential economic growth implications were broadly covered by the adverse scenario, which assumed a general, severe worsening of all the main economic and financial variables for the UK. For individual banks, however, Brexit could have severe effects.