Stress Testing - the upcoming post financial crisis challenge
Regulators in Europe and the USA are enforcing new policies in response to the last financial crisis which emphasize the need for efficient regulation and stronger supervision. Promoting financial stability by improving accountability and transparency in the financial system is a key topic for regulators and the last six years have seen continuous regulatory projects to this end.
Stress testing, where the strength of a bank's ability to deal with rious economic events, either at a macro level, or micro - client or instrument - level is assessed, is an important component of this initiative, as it acts to strengthen the resilience of the financial services to adverse economic conditions.
The table above illustrates the key differences between the stress tests worldwide. Each of the regulators has its own approach in terms of data requirements, one of the most important aspects of these tests. The financial regulators will use the data submitted to improve their models and to analyse the systemic risk and stability of the main financial institutions.
Financial regulators also select the scope of the analysis. The main goal of restricting the number of financial institutions impacted by these tests would be to manage the cost of such examinations whilst obtaining an image as fair as possible of the impact of adverse macro and microeconomic conditions on the financial system as well as on individual banks.
Note that the stress tests are not necessarily run every year. For instance in 2015 the ECB will only run a transparency exercise - banks submitting key ratios and financial data. The ECB decided to skip a year of tests since the results of 2014 stress tests were encouraging. This sends an important message to the banks; if they adhere to financial regulators’ rules, they may be rewarded with lighter pressure for future exercises.
Data given by the regulators to create the adverse conditions scenarios is one of the main components of the stress tests. Each regulator stresses different criteria.
The ECB gives general guidelines:
1. Macro-economic inputs
- Increased bond yields
- Deteriorating sovereign credit quality
- Failure to implement balance sheet enhancements and political reforms
2. Micro-economic elements focused on
- Credit and market risk
- Sovereign bonds
- Interest-bearing transactions
- Other risks (haircuts for property funds, static increase of operational risk…)
The BoE uses the ECB’s stress test structure with added components:
- A sharp depreciation in sterling (by 30%) and pick up in unemployment
- A build-up in inflationary pressures (6.5% inflation)
- A weaker productivity growth impacting GDP
- A fall of CRE prices by 30%, of house prices by 35% and of UK financial assets by 30%
And the Federal Reserve includes 23 variables in its scenarios:
- Six measures of economic activity and prices
- Four aggregate measures of asset prices or financial conditions
- Six measures of interest rates
- Three variables for each one of the 4 countries or country blocks of the analysis
The main issue with this focus on precise features is that banks may put these elements under more scrutiny and invest more to mitigate the impacts these create. In doing so banks may underinvest in the monitoring of other key risks elements, allocating sufficiently to just to pass the tests, thus potentially creating new instabilities in the financial system.
The BoE initiated its own stress tests between 2013 and 2014, and planned to increase the number of financial institutions involved in these examinations.
In the US the number of assessed banks grew by more than 30%, but the ratio of failures dropped from 21% in 2011 to 3% in 2014. Conversely, in Europe, the number of examined banks increased from 90 in 2011 to 123 in 2014. The percentage of failures remained quite stable at about 10%.
This could be explained by at least two factors:
- Financial regulators are designing increasingly more stringent and comprehensive tests. Depending on how demanding each regulator is, this could lead to gaps in the results.
- In Europe, banks subjected to the EBA stress tests are from various countries with different regulations. There is complexity to a fragmented regulatory environment such as Europe, meaning it is difficult to meet 'centralised' regulatory standards.
Financial regulators are becoming increasingly focused on stress tests as they are a win-win exercise; access to precise internal information of certified quality that can be used for further monitoring, while ensuring the financial institutions subject to stress testing are sufficiently robust.
Banks may have a harder time seeing the benefits of such stringent examinations as they have to invest time and resources to train their workforce and run mock tests in addition to the actual stress test. Some banks have started to turn to automated systems and analysis tools to reduce costs and save time.
Further, financial regulators are well aware of the limitations of their stress tests, which is why they have been updating the existing assessments and considering new ways to protect their economies against systemic risk and the “too big to fail” notion.