The European Banking Authority (EBA) officially launched on January 31st the EU-wide stress test corresponding to 2020. Remember that this global stress exercise, which includes all types of risks, is carried out in the even years, while in the odd years, the EBA conducts specific stress exercises (for example, in 2019, liquidity stress).
This year ‘s exercise is launched amid considerable controversy about the effectiveness of the same as it is currently designed. Both Jose Manuel Campa with Andrea Enria, have commented on several occasions how important is for the exercise methodology to capture with maximum accuracy potential risks which European banks are exposed to. In fact, EBA has launched a consultation paper to introduce potential changes for the 2022 exercise. On the other hand, the controversy has also been provoked by the letter that the ECB has sent to financial institutions urging not to compare and align results with comparable banks, either by directly sharing information or through consulting companies.
The main novelty is that, on this occasion, the adverse scenario contemplates a recession scenario combined with very low or negative rates, over a long period of time. Specifically, a fall in the EU GDP of 4.3 %, an increase in the unemployment rate of 3.5%, a fall in stock market indexes of 25% (40% in the case of emerging countries), is contemplated, a decrease in the housing value by 16% and 25% in the case of commercial premises, accumulated until 2022. This scenario involves the materialization of the main risks identified by the ERSB (European Systemic Risk Board), and It has been calibrated by the ECB and the EBA itself. This very acidic scenario would also lead to increases in the risk premiums of public and private debt, and would lead entities to seek profitability in exchange for underestimating the risks in the pricing of operations.
The results of this exercise are expected to be published on July 31st of this year. From that moment on, we will have comparable information on the resistance of large EU banks (including even British banks) to economic shocks. In addition, the results will be another input for Supervisor Review and Evaluation Process (SREP). From its side, the ECB will conduct a parallel stress test for 35 significant banks that are under its supervision but have not entered into the EBA selection criteria.
In this article, we will focus on high-level methodological aspects, included in the section directly associated with balance sheet risk, specifically in the Net Interest Margin (NII).
- General scope of stress exercise.
Banks must make two projections, one based on the baseline scenario and the other applying the adverse scenario described above. An important aspect to take into account is that the two components of the interest rate, the reference rate (risk-free curve) and the spread applied by the bank (for credit or liquidity risk) for the different operations must be separated. This is particularly important and complex in the case of fixed rate products, which should consider the free rate risk for the original expiration of the transaction to deduct the spread of the operation.
Such statements are subject to certain restrictions, mainly in the sense that the outcome of simulations under the adverse scenario should result in losses compared to the result of 2019 and should consider the impact of the provisions of NPL (non-performing loans).
In both scenarios, all sight accounts will be considered as immediately reimbursed (not as in the 2108 exercise). Also in both, future rate curves should be applied consistent with the macro scenario proposed, and considering, in the renewal of liabilities, a minimum set by the increase in financing premiums of both the country (measured taking into account the 10 years term), as of the bank itself (idiosyncratic risk).
In the case of fair value positions (FVOCI, FVPL and accounting hedges), only interest will be considered, since the impact on market value will be reflected in the market risk stress.
The commissions included in the NII must also be part of the stress exercise. The rest of the commissions are excluded from it.
- Relevant assumptions and considerations and information requirements.
Static balance, projections must be made with a new flat business (that is, new operations maintain the amount and financial characteristics) in both scenarios. Derivatives must be included.
The optionality of customer behavior will not be considered. That is, they will not be considered prepaid and sight accounts have no duration. In the case of callable issues by the holder, the first exercise date will be considered as expiration.
In the case of instruments with implicit financial options, banks must separate both components, apply the corresponding methodology to each party and also report the results separately.
The NII stress methodology will not be applied to instruments eligible as AT1.
As described above, certain restrictions on the result apply, considering provisions for NPL, obtained in the case of the adverse scenario. Specifically, it is intended to avoid compensations between losses due to the increase in the volume of NPL and earnings for the increase in income for the rest of the loan portfolio. In practice, this means that the income in the credit investment portfolio in a regular situation has a cap according to the results of the previous year. All this applies at the aggregate group level.
A very relevant metric in the year is the calculation of the EIR (effective interest rate and defined as interest income and expenses with respect to the average volume in a given period). Proof of this is that they include a series of applicable restrictions to ensure the consistency of the EIR and its components along the entire simulation horizon and with respect to the point of origin (2019).
Finally , we would like to highlight that , since a variation of monetary policy is not considered in the stressed scenarios, banks are expected to maintain the same spread currently applied by the Central Bank (calculated as the current rate minus the relevant market rate in the short term) in simulations.
In conclusion, the high degree of complexity that involves the exercise of stress is deduced for financial institutions. During these months, a large amount of resources will be devoted to the execution of this regulatory requirement and, in turn, the ALM tools will be subjected to a stress exercise, to try to cover all the requirements as far as to calculation and parameterization.
It is clear, then, the importance of banks having an ALM tool that is flexible enough, manageable, powerful and accurate to be able to perform the simulations meeting all the requirements and minimizing as much as possible the dedication of resources during the first half of every year.