In a bid to restore confidence in the banking sector, tests have recently been conducted in EU member states to assess their banks’ ability to survive future economic shocks. Dubbed as stress tests, seven of the 91 European banks that underwent such tests have failed. Out of these seven banks, five were based in Spain. These banks hit failure mainly due to their lack of adequate capital to withstand insolvency.
Although most banks fared well - indeed less than eight per cent of the selected banks failed the stress tests - the toughness of these tests has been put in doubt. A large number of regulatory experts have argued that these tests were cushioned and their results did not provide a true picture of the banks’ stability but rather gave a false sense of security to investors.
In view of this, the Committee of European Banking Supervisors (CEBS) revamped its guidelines for the first time since 2006 requiring banks to undertake more rigorous stress tests on the risks they are taking. The newly published guidelines on the identification and management of risks will compel banks to better estimate the losses they might take on their investments to ensure they do not sink when market conditions change for the worse.
The guidelines, which must be implemented by national regulators by the end of this year, recommend that stress tests are integrated into a bank’s internal risk management systems and their results be the starting point of its decision-making when taking risks. The CEBS considers stress tests to be key risk management tools in themselves which allow better understanding of an institution’s risk profile and its resilience to internal and external shocks.
A novel tool recommended in the guidelines is the so-called “reverse stress test” which requires banks to test their stability by assuming a failure situation and then work backwards to determine which risks caused their imaginary collapse. This test is different from an orthodox stress test which normally presents a particular scenario, on the basis of which banks assess whether they would have sufficient resources to avoid breakdown and pinpoint possible threats to their solvency.
In addition, the new guidelines require banks to assess whether they are able to meet minimum capital levels over a longer period of financial stress, consider the interplay between different types of risk and conduct the tests independently and collectively across a range of the bank’s business units and subsidiaries.
The stress test results indicate that €15 billion in further capital injections are needed in 65 per cent of EU’s banks.
Even therefore by the standards of the old stress test guidelines, many European banks will have to strive hard to finance themselves. Yet, a step in the right direction has been taken with the overhaul of the guidelines, adherence to which, will minimise bank crisis in the future.
jgrech@demarcoassociates.com
Dr Grech is an associate with Guido de Marco & Associates and heads its European law division.