Today, July 30, the results of the stress test exercise carried out every two years by the European Banking Authority (EBA) and the European Central Bank (ECB) to measure banks’ resilience to adverse situations are being published; in 2021, these tests were conducted during the first half of the year. To date, Spanish banks have achieved good results in these supervisors’ tests, and no negative surprises are expected in this year’s exercise, thanks, among other factors, to their ability to generate earnings, the sector’s efficiency, and the quality of their loan portfolios.
Although these stress test exercises continue to be very demanding in terms of human and IT resources, both for supervisors and for supervised institutions, some improvements have been made since they began back in 2011. First, there is now greater certainty regarding their frequency and the months of the year in which they are carried out, enabling banks to plan resources and workload in advance. Second, the methodology has remained relatively stable in recent exercises, so institutions have not been required to make major system changes from one year to the next in order to run them.
Nevertheless, there is still room to improve certain technical aspects of this supervisory tool, which is useful for detecting vulnerabilities in institutions and highly relevant when determining the level of capital required of each one. Aware of this, the EBA opened a consultation process to modify the methodology for the stress tests to be conducted from 2023 onwards. Its aim is to improve the relevance, comparability and transparency of these tests, and to strike a balance between cost and efficiency.
One of the main weaknesses of these exercises is the assumption of a static balance sheet: during the three-year period over which banks’ financial variables are stressed, balance-sheet management actions to mitigate the impact of the stress are not allowed. This assumption undermines the credibility of the exercise’s outcome, since in real life institutions would manage their balance sheets to reduce the adverse effect of stress.
Another weakness, which mainly affects Spanish banks, is that the current methodology does not take into account the benefits of geographic diversification. In other words, the scenario stresses the macroeconomic variables of all jurisdictions equally, without considering the beneficial impact of the negative correlations that exist between jurisdictions. There is historical evidence confirming the negative correlation between events occurring in different geographic regions; that is, the negative effects of a crisis in one region would be offset by the positive effects of other events in another region. But this is not taken into account.
This weakness is linked to another, more technical one concerning the treatment of the exchange rate applicable to institutions with business in third countries. The methodology stresses the exchange rate for transactions in currencies other than the euro. The problem faced by institutions with subsidiaries in third countries is that the methodology stresses a large part of income items, which are reduced by the exchange-rate effect, but does not stress most expense items—mainly provisions—so these are not reduced by the exchange rate. As a result, the exchange-rate impact on subsidiaries is overstated.
Moreover, it is also important that the methodology applied to exercises carried out from 2023 onwards provides a stronger link between the stress test outcome and supervisory measures. At present there is no clear link between the results of the exercises and supervisory measures, mainly the capital add-on known as ‘P2G’. The fact that institutions with very different results in the exercise could have similar ‘P2G’ requirements would undermine the credibility of the exercise.
Finally, it is important to avoid supervisory biases during the exercise. While methodological stability has provided a certain degree of certainty for institutions, this has been offset by supervisory adjustments to projections during the “quality assurance” process when they do not align with supervisory expectations. It is necessary to limit these supervisory adjustments to give the exercise greater relevance and credibility.
All these weaknesses mean that, among other things, banks cannot use these exercises and their results for internal management purposes, which represents a waste of resources.
Stress tests are a necessary tool for identifying vulnerabilities in institutions. Nevertheless, it is necessary to address the weaknesses they present in order to capture the strength of each European bank as accurately as possible.
Pedro Cadarso, Public Policy adviser at the Spanish Banking Association (AEB)
