ALERT

May 2014

Stress tests: another way to impose higher capital requirements

In the detail…

Scope

The EBA stress tests will apply to 124 banks across the EU, covering at least 50% of the national banking sector in each member state. The tests will apply on a consolidated basis.

Timing

Data templates and guidelines were distributed to banks immediately after the announcement of the scenarios and methodology. The first round of data collection is due to be completed by the national supervisors by the end of May, with preliminary results submitted to the EBA in mid-July, and near final results in early September. Following quality checks, the EBA expects to publish the results for each bank in October this year.

For banks in the banking union, the AQR should therefore inform the starting point for the stress test.

Scenarios

The EBA stress test is based on two main scenarios, running from 2014 to 2016. The “baseline scenario” is a macroeconomic forecast prepared by the European Commission, with real GDP growth of around 2 percent in the EU in 2015 and 2016. Meanwhile, the “adverse scenario” has been designed by the European Systemic Risk Board to reflect a set of systemic risks, including:

A sharp increase in global bond yields;

An abrupt reversal in risk sentiment towards emerging market economies;

A further deterioration on credit quality;

Renewed doubts over fiscal sustainability; and

A contraction in the availability of market funding for banks.

Directly or indirectly, the assumed crystallisation of these systemic risks lead to:

Real GDP being 7 percent lower in the EU than in the baseline scenario by end-2016, 6 percent lower in the US and Japan, and up to 10 percent lower in emerging market economies;

EU unemployment rate 2.9 percentage points higher than in the baseline scenario by end-2016;

A spike in long-term government bond yields at the end of 2014, at 250 basis points above baseline in the US, 150 basis points on average across the EU, and over 300 basis points in Greece;

Corporate bond spreads and euro swap rates also increase relative to the baseline scenario;

Banks’ longer-term funding costs reflect these increases in bond yields, while their short-term funding costs rise by 80 basis points;

Equity prices are 18-19 percent lower than in the baseline scenario on average across the EU;

House prices are 21 percent lower than in the baseline scenario on average across the EU, with country-specific shocks ranging from 8 percent to 34 percent;

Commercial property prices suffer a smaller shock than house process, with an average decline of 15 percent against baseline across the EU and country-specific shocks of between 4 percent and 27 percent; and

Central European economies experience a 15-25 percent depreciation of their currencies, resulting in particular in a deterioration of the solvency of borrowers with foreign currency debts.

Methodology

Banks are expected to take the baseline and adverse scenarios and to assess their impact on their capital ratios, with the impact of the adverse scenario passing through a number of transmission mechanisms, including net interest margins, loan and trading book losses, higher provisions, and higher risk weighted assets.

Within this approach, securities (including government bonds) held in the trading book will be subject to a mark-to-market treatment, with losses realised immediately. In the banking book, securities held to maturity will be subject to an upward shift in risk weights and higher impairment rates, while available for sale securities will be subject to a fair value treatment, with a gradual phasing out of prudential filters.

A “static” balance sheet is assumed, precluding banks from taking defensive actions such as selling assets.

Results and actions

The impact of the stress tests will be assessed in terms of the common equity tier 1 (CET1) capital ratio, using the transitional arrangements that apply in 2014 – 2016, as set out in the Capital Requirements Regulation. Banks are expected to meet an 8 percent CET1 ratio under the baseline scenario, and 5.5 percent under the adverse scenario.

Banks are already expected to “front load” their actions in response to the likely outcomes of the AQR and the stress tests, and supervisors will decide what further actions – if any - need to be taken as a result of the stress tests.

Member state discretion

National supervisors are required to run the common baseline and adverse scenarios, and the EBA will report the results of these stress tests.

In addition, however, national supervisors can apply additional or more severe country or bank-specific shocks to banks under their jurisdiction; apply more severe hurdle rates that banks have to meet; and apply the tests to a wider range of banks.

UK variant

The Bank of England has exercised its discretion to set tougher stress tests for a wider range of UK banks. Its tests will apply to eight UK banks. Barclays, HSBC, Lloyds and RBS are already in the EBA exercise, but UK exercise will also be applied to Co-operative Bank, Nationwide, Santander UK and Standard Chartered. These eight banks will have to run stress tests based on (i) the European Commission’s baseline scenario, (ii) the EBA’s adverse stress scenario, and (iii) the Bank of England’s adverse stress scenario.

The UK-specific adverse stress test will be more severe than the EBA adverse stress test. In particular it will include:

A 30 percent depreciation of sterling;

Gilt yields peaking at just below 6 percent (rather than at 4.3 percent under the EBA test);

House prices falling by 35 percent from their end-2013 level (rather than by 20 percent under the EBA test);

Commercial real estate prices falling by 30 percent (rather than by 18 percent under the EBA test);

Equity prices declining by 30 percent (rather than by 15 percent under the EBA test); and

Real GDP falling to 3.5 percent below its end-2013 level, and unemployment rising to 12 percent. Taking into account the fall in real GDP since 2008, this would represent a similar cumulative contraction in real GDP to the experience in the immediate aftermath of the First World War.

It is also clear that the bank of England intends to use a range of models to assess the “transmission mechanism” from this scenario to the impact on banks’ capital ratios.

The UK will set a lower (easier) hurdle rate for its more severe stress test, at a 4.5 percent CET1 capital ratio, although at least part of this easing will be offset by using the “fully loaded” capital ratio rather than the transitional version used by the EBA. Under the UK-specific stress test banks will also be able to assume that they can take limited management actions that are consistent with their recovery plans and would be feasible under severe market-wide stresses.

Comparing stress tests

It is difficult to compare different adverse scenarios, but the table below shows the key elements of the adverse scenarios under the EBA, Bank of England and recent Federal Reserve Board CCAR exercises. This shows that the Bank of England adverse scenario is tougher than the EBA equivalent, while the US exercise generally assumed much sharper adverse variations in 2014 followed by a recovery from 2015.

Adverse stress scenarios

 

EBA (European Union area)

UK

US CCAR (severely adverse scenario)

 

2014

2015

2016

2014

2015

2016

2014

2015

2016

Real GDP (% growth)

-0.7

-1.5

+0.1

-2.5

-1.1

+1.2

-3.8

+2.0

+3.9

Unemployment (% level)

11.3

12.3

13.0

9.3

11.1

11.8

11.1

11.1

10.4

Government bond yield (% level)

4.4

4.3

4.4

5.5

5.7

5.3

1.3

1.6

2.0

Equity prices (% deviation from baseline)

-19

-17

-19

-27

-24

-12

-22

+33

+14

House prices (% growth)

-8

-6

-2

-12

-25

0

-15

-11

+2

Commercial real estate (% growth)

-4

-4

-1

-15

-15

-2

-27

-12

+6


One further perspective on comparing stress tests is to compare the EBA approach with that of the recently announced European Insurance and Occupational Pensions Authority (EIOPA) stress tests for European insurance companies. As would be expected, the insurance stress tests focus more on the specific risks facing insurance companies, including (a) a continuation of very low interest rates, with an impact on guaranteed life insurance payments; (b) two different market stress tests, one with a sharp increase in bond yields and other interest rates, and the other with a sharp decline in equity prices; and (c) five claims-related shocks ranging from longevity assumptions to catastrophes.

Further insights

To discuss the implications further please contact Giles Williams or Clive Briault.

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FINANCIAL SERVICES

Giles Williams

Clive Briault

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