Recently, a press release has been published on the ability of European banks to withstand a prolonged crisis situation affecting their liquidity. This article is based on the results of a stress exercise required by the European Central Bank for a total of 103 national banks directly supervised.
According to this article, readers may have come to two very different conclusions about the strength of European banks. While some headlines state that 90% of banks have sufficient liquidity, other publications report that half would not withstand a liquidity crisis. Interpreting the results properly may require some more in-depth analysis.
Origin of the Stress Exercise.
Every two years, European banks carry out a general stress exercise (even years) and, between these, the ECB requires “thematic” exercises. In 2017 it was about Interest Margin and in 2019 it was about liquidity. It is worth remembering the recent experience of Popular, Veneto, Popolare di Vicenza, for example. In this way, the ECB has conducted such a supervisory exercise to prevent similar situations. It has been called LiST (Liquidity Risk – Stress Test) 19.
Main methodological issues.
It has been focused on short-term liquidity risk (up to 6 months), based on the COREP C66 report that institutions must submit regularly to the ECB, but with some modifications and necessary additional information such as collateral. This report estimates a survival horizon, under a base scenario, which measures the number of days a bank can cope with net liquidity outflows using the liquidity generating capacity available at the time of analysis.
The survival horizon is also calculated under two idiosyncratic scenarios with different degrees of severity (calibrated according to recent episodes of liquidity crisis). It is not the purpose of this article to review in detail the methodology applied, but some of the impacts that should be evaluated would be:
- Adverse shocks, more intense outflows in time and sight deposits, outflows due to a notch drop in the rating and contingent liquidity outflows.
- Extreme shock, outflows due to a decline in three notches, more severe outflows of liquidity (greater outflows of time and sight deposits and greater outflows due to contiguous obligations).
In addition to the consolidated level calculation, a detailed analysis is performed for the most significant currencies and for different levels of sub-consolidation. The analysis is aimed to obtain granular information to assess the distribution of liquidity within groups and potential significant liquidity gaps in currencies other than the euro.
The stress exercise is incorporated into the SREP (Supervisory Review and Evaluation Processes). Although the results will not have a direct impact on capital requirements, they will be integrated into the Liquidity Adequacy Score.
Within the scope of the stress exercise, a consistency analysis is also performed with other regulatory liquidity reports and it is estimated when the LCR would fall below 100%.
- The average percentage of liquid assets is 23% of the total. Although banks have the capacity to generate additional collateral by an average of 6%, so that total liquid assets amount to approximately 29% of the total. In relation to that, larger banks are indeed more active in collateral management.
- About 90% of banks would survive at least two months in the extreme scenario, in which outflows account for 27% of total assets (in six months). The average survival time is 176 days for the adverse scenario and 122 days for the extreme scenario.
- The results obtained for a 30-day horizon are consistent with the reported LCR.
- Larger banks are more exposed to liquidity risk because less stable deposits and wholesale funding have more weight in their funding mix.
- In relation to the granular analysis, it is verified that:
- Survival horizons in foreign currency are about half that of the balance sheet in euros (in several cases, even horizons are less than 30 days).
- Subsidiaries outside the euro area have shorter horizons because they have lower liquidity reserves and are more exposed to wholesale and intragroup financing.
- Some banks show a very significant drop in liquidity after 30 days as a result of a strategy to optimize the LCR. In these cases, the regulator will initiate a one-to-one dialogue process with the concerned bank. In addition, the use of collateral swaps will be discussed further in order to analyze the potential systemic implications of the interconnection it creates between financial institutions.