European banking stress tests 2014: A more adverse approach for a shorter banking sector

Press conference by Michel Barnier, Member of the European Commission, on the establishment of a Single Resolution Mechanism for the Banking Union. (EC Audiovisual Services).

The aftermath of the financial crisis of 2007-2008 is mainly related to the banking sector. The capital adequacy of the European banks is an important aspect that European Regulation Bodies have to be aware of. During the past years the European Banking Authority (EBA) and the Committee of European Banking Supervisors are setting up simulations that determine the ability of banks to face an economic crisis, the so-called “banking stress tests”.

The failure of past stress tests

The scenarios that the previous years’ tests (2009, 2010 and 2011) were relying on were not in line with reality. This was proved by facts such as the bail-out of Dexia, a Franco-Belgian bank which was rescued by the French and Belgian government in 2011 while it had passed the stress tests some months ago. Therefore, the EBA is going to release today in London the final key features of the EU-wide stress tests 2014. The EBA in collaboration with the European Central Bank (ECB) have come up with analyses that will allow them to test if European banks have the necessary capital to absorb and cover a certain amount of losses and also accounting for possible risks in the coming years (2014-2016). This exercise will use balance sheet’s figures at the end of 2013. The tests are supposed to be based on stricter assumptions compared to the ones introduced in 2009, 2010 and 2011.

Implementation of stress tests

EBA had already started a preliminary discussion with the banks involved regarding the methodology and templates for the 2014 EU-wide stress tests on the 4^th of March 2014. The expected starting point is the month of May and the results of the implementation will be reported at the end of October. More specifically, 124 “systemically important” banks of the European Union (EU), which cover at least 50% of the banking assets of each country, will take this exam. There will be two scenarios that the banks will be tested, the baseline and the adverse scenario. Their difference is that the latter’s assumptions are more pessimistic than the former’s. Moreover, the risk-based capital ratio of the banks must be above 8% in the baseline and 5.5% in the adverse approach.

A static balance sheet to a stricter test

The underlying assumption implies no new growth and constant business mix and model throughout the whole time horizon. A forecasting hypothesis like that intervenes in the banking active management and is highly likely to produce pessimistic results. Thus, it is crucial for the regulators to have this in mind when interpreting the outcomes of the tests. Added to this is the fact that the EBA and the ECB are afraid of events like the Dexia’s bail-out or the low capital reserves of Greek and Italian banks. However, the predictions that they impose in both scenarios are too gloomy compared to what we have already experienced but an economic crisis like the one we recently faced is not unlikely to happen again.

Not enough austerity

What will be the outcome of these stress tests and how is it going to affect the banking sector? The European regulating bodies are determined to change the outlook of this sector once and for all. These rigorous measures will reduce the great number of banks and will leave only the ones that “deserve” to be there. Actually, this exercise is nothing but a part of Basel III (or the Third Basel Accord) regarding banks’ capital requirements. There is no excuse for the banks that will fail to pass this exam because they were fairly notified beforehand. It is worth also mentioning that the United States (US) stress tests are more severe than the European equivalents. But it is more proper to wait and see the final details of the EU stress tests in order to be able to analyze more in depth their severity.