Search:
Membership
Application Forms

Enquiries
Email: membership
Tel: +44(0)131 473 7777


Europe's stress tests:
Under pressure

Last year’s ‘stress testing’ of Europe’s banks was widely denounced for clearing several which then had to be bailed out. This year’s tests are tougher, but JOHN THIRWELL wonders if they’re tough enough to forestall a crisis.

In July last year, the Committee of European Banking Supervisors announced the results of the stress tests undertaken that spring by 91 banks around Europe. With the memory of the banking crisis still fresh, the tests had already been denounced as too mild by almost all commentators.

When only seven banks failed and were required to raise more capital – Germany’s Hypo Real Estate bank, Greece’s Atebank and five in Spain – and that only a modest 3.5 billion, there was another outcry. But it was nothing compared with the one which greeted the subsequent bail-outs of banks around Europe, including especially the Irish banks, which had all passed the tests.

So here we are again: 90 banks are taking part in the 2011 tests, the results of which should be announced in a few months. They’re based in 21 countries, represent more than 65 per cent of European banking assets and more than half of the banking assets in each of those countries. Will things be different this time?

Stress testing is nothing new

One thing certainly is different: the tests are being run by the European Banking Authority, the new European banking superregulator. And the criteria will be much more stringent, according to the EBA’s Chairman Andrea Enna. But then they will have to be, if the new authority is to maintain any credibility.

The 2011 tests combine three elements: a set of EU shocks, a global negative demand shock originating in the US and a significant US dollar depreciation against all major currencies. The EU shock scenario includes a 4 per cent drop in GDP from projected levels through to the end of 2012, a 10-20 per cent drop in European shares, a sharp decline in the real estate market and a 125 basis point increase in short-term interbank financing costs.

Perhaps the most significant change is this: the 2010 test was to see whether a bank’s total Tier 1 capital would be at least 6 per cent of risk-weighted assets after the tests had been run (as opposed to the regulatory minimum of 4 per cent); this time, the exercise will test against a ‘core’ Tier 1 (CT1) capital level of 5 per cent, as opposed to the current minimum of 2 per cent.

If scenarios are intended to be severe but plausible, these criteria would seem to fit the bill. But they haven’t silenced the critics. They point out, for instance, that Basel 3 sets a minimum CT1 of 3.5 per cent from 1 January 2013, rising to 7 per cent by 2018. The EBA’s answer is that Basel 3 is subject to transition arrangements and so is not strictly comparable.

Perhaps a better line of attack for the critics would have been to point out that Ireland is imposing a 10.5 per cent CT1 requirement on its banks (with a target of 12 per cent), Spain is moving to 8 per cent and Sweden is aiming for a target ratio of 10-12 per cent.

These, of course, are all countries which have suffered serious problems and are indicating to the markets what they are doing to ensure no repeat. With over 20 countries to bring into line for an agreement, many of which consider that their banking system was and is robust, it’s not surprising that the EU requirement is less onerous than these countries’ targets.

It really all depends on what the tests are trying to prove and whether they will reinstate market confidence into the European banking system. The tests may suggest that individual banks are relatively safe, but markets and analysts will concentrate on specific countries or banks which they believe are weak.

It is here that the target countries, perhaps by changes to their capital regimes or through more extensive nationwide stress tests, such as the one currently being undertaken by the FSA, will have more effect on market sentiment.

Then there is the extent to which banks make public the results of their own internal tests. After all, stress-testing is nothing new. It is part of banks’ normal contingency planning. A bank which can demonstrate to the market – and to its regulator – the extent of its efforts to prevent a re-run of 2007/9, should benefit.

The EU stress test depends crucially on capital adequacy as its measure of stability. But is that really enough? The banking crisis was caused as much as anything by poor behaviours, which purely financial tests cannot accommodate. And, o course, a critical element of the crisis was its systemic nature, again something which the tests are not designed to cover.

The macroeconomic consequences

In a speech last month to the Cass Business School in London, Lord Turner, Chairman of the FSA, suggested that CT1 capital ratios should probably be in the 15-20 per cent range with even higher ratios for systemically important banks. He also said that shadow banking was probably just as important as regulated banking if we are looking to prevent the crisis repeating itself.

He went on, though, to focus on the need to allow for nonrational decision-making and for myopia, some of the ‘people risk’ elements of the crisis. And finally he turned to the need to focus on systemic stability and macroeconomic consequences. In that connection, it’s worth asking whether macroeconomic shocks cause financial stability or the other way round.

Understanding systemic risk is the big imponderable. It was fascinating to read the paper earlier this year in the scientific Nature magazine, written by Andrew Haldane, Executive Director, Financial Stability, at the Bank of England, and Robert May, former Chief Scientific Adviser to the UK government, which looked at how biology might help us to better understand how systemic contagion can arise.

But even if we do get a better understanding of systemic risk and can better control poor behaviours, the biggest question of all will be whether regulators will be able to continue to drive for still higher capital standards and more intensive supervision when the financial system is stable and the economic cycle is on the up. That is the real challenge for when the next crisis starts to bubble and certainly beyond the scope of the current EU stress test.

THE CORE QUESTION: who’s right?

As a measure of a bank’s financial strength, what level of Core Tier 1 capital should it be required to hold?

2% current minimum level of Core Tier 1 (CT1) capital
3.5% minimum CT1 level set for 2013 by the Basel 3 accord
5% minimum CT1 level set in the current EBA ‘stress tests’
7% minimum CT1 level set for 2018 by the Basel 3 accord
8% minimum CT1 level to which Spain is moving for its banks
10-12% minimum CT1 level which Sweden has set for its banks
10.5% minimum CT1 level set by Ireland with a target of 12%
15-20% CT1 range suggested by FSA chairman, Lord Turner

JOHN THIRLWELL is an independent adviser on risk management to boards in financial services and co-author of Mastering Operational Risk (Financial Times Prentice Hall, 2010).

Back to Special Report contents
Back to Magazine contents

Chartered Banker - the premier qualification for professionals in financial services

Chartered Banker is the most prestigous qualification in the world for bankers and financial professionals.