• Peter Farley, Senior Capital Markets Strategist at Misys


• 28.07.2016 07:30 am
undisclosed

The results of the latest ECB stress tests on European banks, due on 29 July, will determine whether the banks have sufficient capital buffers to withstand theoretical adverse swings in asset prices, interest rates and other macro-economic variables.

At its heart these stress tests are designed to “assess banks’ ability to meet applicable minimum, and any additional, capital requirements under stressed conditions”, according to the European Banking Association, which is co-ordinating the exercise. The revised approach is also placing a greater emphasis on quality, with an expected higher stressed dilution of capital.

Much has been written recently about perceived capital shortfalls across European banks, particularly in Italy where non-performing loans are having an insidious effect. Investors will therefore be looking for some reassurance that the authorities will at least be using this exercise to restore some confidence in the sector. Although this is the most comprehensive of these industry-wide assessments by the ECB, some are still questioning whether the regulator is using the right criteria to properly assess bank vulnerability. What is certain though, is that in the new ecosystem envisaged by the ECB, banks will need to demonstrate that smarter data management practises are in place in order to manage risk and more effectively allocate capital.

The ECB has also clarified that its stress tests of the 51 banks selected (comprising around 70% of the EU’s banking sector) will not be making any pass/fail judgement of individual banks. The exercise is rather designed to “be used as a crucial input into the SREP (Supervisory Review & Evaluation Process) analysis for 2016.”

The review, which took place between March and July, encompasses the few EU banks deemed globally systemically important (G-SIBs), as well as tier one local and regional banks. These include 39 banks under the Single Supervisory Mechanism (SSM) and 12 others. But it should be said that these banks already tend to have both higher capital ratios and lower levels of non-performing loans than smaller counterparts.

The principal areas of focus were around credit and market risk, as well as all financial assets and liabilities. For the first time there will also be an analysis of the impact on bank P&Ls with regards to conduct and other operational risks. The intended end result is a methodology to identify and integrate a regulatory capital management framework with the stress tests, similar to that introduced by the Bank of England a year ago.

This would include Pillar 1 and 2 base levels (up to 5.5%), and the G-SIB Buffer (a further 2.5%) up to the minimum required tier 1 capital of 8%. In addition, there should be a Conservation Buffer of a further 2.5%, a Counter-cyclical Buffer of another 1.5% and lastly a PRA Buffer of 1% for a potential total of 13%. If stress test losses go below the Pillar 1 & 2 levels capital actions will be required. It all adds up to a lot of money tied up in unproductive assets.

Banks will certainly be safer, but they will struggle to generate profits, particularly in the current interest rate environment. But some are already questioning the process and methodology that has been adopted, which is seen as a top-down approach that only analyses the impact of market and macro-economic changes on a bank’s capital ratios. Far more effective, argue some analysts, would be to employ the SRISK methods. This SRISK approach, developed by professors at the NYU Stern School of Business and the University of Louvain-la-Neuve, challenges a bank to re-calculate how much more capital it would need to raise to maintain capital ratios during stressed economic conditions and what it would cost to do it. This, they believe, is more important to know than just how much capital ratios would fall. After all, if those ratios drop the banks will be required to start repairing balance sheets during the economic turbulence, not just allowed to wait for normal market conditions to be restored.

Under this methodology, the impact on many bank balance sheets produces considerably greater dents than the ECB’s adverse scenario approach due to the need to include forced asset sales, or capital dilutions from the prices potentially paid to raise it, during abnormal markets.

Banks will be steadily expected to take on more regulatory obligations that will, in effect, see them being forced to build these type of stress tests into their day-to-day business models. In particular, the advent of the FRTB (Fundamental Review of the Trading Book) effectively forces banks to test potential trades and actions prior to their execution to demonstrate any potential impact on P&L and balance sheet in adverse market conditions.

This will require the adoption and integration of more sophisticated data management and analytic capabilities to be able to show regulators that these risks are being understood. Banks will have to seriously consider the strategic implementation of technology that delivers visibility both within asset classes, as well as across the enterprise, and, most importantly using consistent data sets in as close to real-time as is feasible.

These challenges should not be underestimated, whatever the results of the latest ECB exercises. Regulators are being clear: they want banks to deliver more transparency, more risk awareness and more confidence in bank decision-making – and any ramifications that may result. It is not something that can be postponed any longer.