A new stress test for European banks

One of the most significant developments is the smaller sample of banks. It will now cover 53 of the largest institutions, not 123 like the last stress tests. The supervisor will subject the other banks to a similar test but will not publish the results. The six largest Spanish banks (BBVA, Sabadell, Popular, Santander, Bankia and Caixabank) are all included in the public exercise.

Another change is that there will not be a minimum capital requirement for banks. Instead, the supervisor will set a threshold for each institution that will not be published. The results will be particularly significant because they will become part of the periodic Supervisory Review and Evaluation Process that determine the capital requirement for each bank (Pillar II).

The inclusion of risk stemming from misconduct is also new. This aspect of the stress test looks at potential losses from banks behaving unethically.  Banks have made a major effort to improve their procedures and internal governance in order to ensure that they act ethically, and this should be reflected in the stress test.

The adverse macroeconomic scenarios that will be used to assess the state of the banks reflect the risks the ESRB consider threats to the stability of the European financial sector. They include: an abrupt reversal of compressed global risk premiums, low market liquidity, low nominal growth, weak profitability for banks with increasing concerns over public and private debt sustainability and mounting competition from shadow banks (institutions that are not banks providing financial services).

The scenario focuses on stresses to balance sheets and the results of European banks and those with business on the continent. Shocks for EU economies are considered growth, inflation, unemployment, long-term sovereign interest rates, housing prices, commercial real estate assets, stock exchange indexes, and even exchange rates. This seeks to measure the direct impact of banks’  balance sheets on their European footprint. For economies outside the EU, only the impact of growth and inflation will be provided, which affects the estimates of the banks’ footprint beyond the EU.

Some inconsistencies from the 2014 exercise have been corrected in 2016. For example, for some emerging economies, severe deflation will be included, something that has never occurred and which seems fairly unlikely in a scenario of higher risk premiums considering that local exchange rates will probably depreciate and lead to domestic inflation. The definition is still pending of an adverse scenario regarding exchange rate changes in emerging economies and their impact on inflation rates.

This exercise comes at a crucial moment for European banks as market turbulence seems especially focused on the sector. In this framework, the stress test could serve to rebuild trust in the largest European banks.