The Basel Committee regularly publishes papers – on the way Basel is implemented within the various member jurisdictions across the globe. This implementation looks at Basel II,largely concentrated around the improvement of Credit Risk, Operational Risk, Pillar 2 Supervisory and Pillar 3 Disclosures, Basel II.5,pertaining mostly to Securitisation and Trading Book Exposures, and Basel III, lending itself to the implementation of heightening capital requirement and quality, sensitivity to globally systemically important banks, liquidity coverage ratio requirements, leverage ratio and net stable funding ratio).
The Authority has construed the Regulatory Consistency Assessment Programme (RCAP) Programme, and during such assessments a 3-tier level of assessment is qualified. The first level involves the timely adoption of Basel III; the second level looks at regulatory consistency; and the third level ensures consistency of outcomes (initially focusing on risk-weighted assets) are as intended.
Similarly, the European Banking Authority publishes — information pertaining to the methodologies used for conducting pan-European stress testing exercises on a regular basis. One of its roles is to ensure the effective and efficient operation of the financial framework within Europe. This includes the timely conduct, and publishing of data pertaining to a series of stress tests across 124 banks (a list of which can be found here), covering at least half of a nation’s banking sector.
In close co-ordination with the European Systemic Risk Board (ESRB), the tests will be part of the ECB’s comprehensive balance sheet assessment. The EBA and the ECB have worked together to define exactly what will be required in these tests. Such tests will be conducted namely by the various NCAs, so it would be the regulators who will be conducting such tests that have been earmarked to run from 2014 through 2016.
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”. At a high level, these tests will be comprised by taking the various institutions’ balance sheets as at the 31st December 2013 and run a series of tests. The ECB stress testing is a static stress test, meaning that there will be no assumption of new business throughout the period, but will assume that the average European GDP will fall by approximately 7%, the unemployment will rise to 13% (versus a baseline of 10.1%), EU real estate will decline by 21.2%, EU commercial real estate to decline by 14.7%, as well as a significant currency drop in Eastern Europe.
Overall, this is a tougher stress test than the preceding exercise undertaken in 2011 where the benchmark was 5% to pass, whereas in the 2014 cycle, a benchmark of 5.5% needs to be met. Enria continued: “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”.
In the UK, 4 banks will run stress tests to an additional 8 of its top banks. Albeit a lower test threshold will be set (at 4.5%), the stress testing conditions will be higher. Scenarios will include the Sterling to fall by 30% leading to higher inflation, residential house prices in the UK to decline 35% on average, commercial real estate to decline by 30%, as well as bonds and equities to witness a similar drop in value. Another key difference is that the UK test will be a dynamic test where firms will be required to predict the amount business as well as the amount of run offs at each point in time, hence more difficult to perform, and surpass.
In the US, the Federal Reserve has also embarked on similar stress tests and will be based on 31st December 2013 balance sheets. All banks bearing 50billion or more in assets are required to form part of the stress testing exercises. The threshold, also set at 5%, includes assumptions such as unemployment rate peaking at 11.25%, equity prices to witness a 50% drop compared to their value in Q3 2013 over 9 quarters, and housing prices to dip 25% by mid-2015, represented by a reduction in the house price index. Clearly, such tests also focus on the capital quality and not only on the quantity of assets kept within a financial institution’s balance sheets.
The result of the US stress test show that generally, all US banks are strong enough to withstand tests, with only 1 large bank failing – leading Capital plans for 25 of the banks were approved. It is important to also note that based on the results of such tests, the regulators may hinder banks from distributing profits if it is felt that there is not enough capital for them to allow such distribution.
Overall, comments regarding European stress tests concentrate largely on the fact that a drop in the GDP and unemployment rate was not considered to be overly challenging. All the European banks are expected to pass the quantities test; this is in spite of comments that not enough banks have failed such stress testing. Also, there were comments about no European debt reconstruction being considered as part of the stress testing scenarios; and no stress scenario considering deflationary cycles. However all the banks including European banks have been shrinking their balance sheet and increasing their capital. It is quite clear that the banking sector is in a much healthier position than it previously was. Therefore it is likely that most banks will pass such tests. Contrary opinions to this emanate however, from views such as that of Gonzalo Gasos, Senior Policy Adviser – banking supervision at the European Banking Federation, who is not wholly convinced by the methods.
“It is still too early to provide a detailed analysis, but our overall thinking to date is that the elements of the publication portray a scenario that is unrealistic, and could put EU banks in a worse light than in reality,” Mr Gasos said.
