In order to protect banks from macroeconomic and financial shocks, prudential authorities use a range of risk analysis tools, among them stress tests. What are they? What purpose do they serve? This blog post answers these questions and is accompanied by a second post on the “real-life” stress placed on banks by the Covid-19 crisis.
Stress tests first became part of the regulatory framework in 2004 under the Basel II accords: these accords authorised banks to develop their own in-house risk models in order to calculate their capital requirements. At the same time, however, it also became clear that supervisors needed stress-test tools to allow them to verify the soundness of bank models in capturing a deteriorated economic and financial scenario. With the Great Financial Crisis of 2008, these exercises became even more useful, notably for evaluating and communicating on banks’ ability to withstand a shock of that scale. As a result, the Basel Committee introduced its Principles for sound stress testing practices and supervision in 2009. Stress tests have since become a recurrent exercise at the European level and are carried out every two years by the European Banking Authority.
A stress test consists in simulating the impact of an economic and financial crisis on each of the tested banks and, by extension, on the solidity of the banking system. Since 2009, 6 European stress tests have been carried out, each involving three steps (see Chart 1):
The loss of capital revealed in a stress test is expressed in terms of the decline in the “capital ratio”. Chart 2 shows a very simplified version of a bank balance sheet: the capital (i.e. own funds) is used to cover unexpected losses incurred by the bank on its assets.
The capital (or solvency) ratio is the amount of own funds expressed as a percentage of risk-weighted balance sheet assets, i.e.:
Capital ratio (%) = Own funds/Risk-weighted assets
Risk-weighted assets are defined as the sum of each line of a bank’s balance-sheet exposure multiplied by a weighting that reflects that exposure’s level of risk. Certain assets are deemed to be “risk-free” and are given a zero weighting (0%), for example certain government securities or guaranteed securities, whereas others are considered very high-risk and can have a weighting as high as 1,250% (i.e. full coverage of the asset by capital for a regulatory capital ratio of 8%), for example some equity exposures. The capital ratio is thus a useful thermometer, and any deterioration can be the result of (i) a decline in capital linked to losses (numerator effect); and/or (ii) a rise in risk-weighted assets (denominator effect). Chart 3 shows the capital ratios in December 2019 of the 22 largest banking groups in the European Union.
A bank is deemed to be fragile if, under the stress test scenario, its capital ratio is found to fall below the minimum requirement indicated in the regulations, which is specific to each institution depending on the risks to which it is exposed.
As a result of its role in financing the economy, a bank is exposed to a number of risks for which it needs adequate capital coverage. An adverse scenario affects various classes of risk, notably:
The channels whereby these risks are transmitted are complex and differ according to each bank’s business model. To illustrate (non-exhaustively):
Under the coordinated stress-test exercises, the way banks take these transmission channels into account is determined by the prudential authorities, to ensure consistent treatment and comparability of results. In practice, banks are notably required to use a static balance sheet approach: in other words, they must assume throughout the entire stress test that they do not optimise their balance sheet in response to the shocks but instead undergo them “passively”.
While stress tests have become a vital risk management tool for prudential policymaking over the last few years, both in the United States and Europe, the doctrine, models used and even the lessons to be drawn have not yet been harmonised across jurisdictions and are still the subject of debate. They nonetheless remain an extremely useful exercise that provides visibility over the banking system’s ability to withstand adverse shocks and support the economic recovery in less favourable periods. It should also be remembered that, at the European level, they are used as the benchmark for the calibration of certain bank capital requirements, especially those known as pillar 2.