09 June 2016

ECB: Making sense of the EU wide stress test - a comparison with the SRISK approach

Authors analyse the SRISK measure with respect to its usage as a benchmark for the ECB/EBA 2014 stress test. They find out that the ECB/EBA stress impact is consistent with findings in the literature on credit losses. In contrast, the SRISK measure bears much less relation to these factors.

While the success of a stress test depends on the function it was designed for, the quality of a macro stress test hinges on the plausibility and severity of the scenario and its translation into stress test impact. Ideally, the stress test impact on bank capital should reflect banks’ exposure to a number of risks, most importantly, credit risk due to macro- and micro factors and trading risks related to market exposures. 

This motivates an investigation of the stress impacts of both the European Central Bank (ECB) comprehensive assessment and SRISK  to  examine  how  they  relate  to  a  set  of  factors  that  explain  bank  fragility.  Authors  proceed  by regressing  the  stress  impacts  of  both  measures  on a  set  of macro  variables,  bank  balance  sheet variables and market based measures to better understand the drivers behind the stress scenarios.

They focus their analysis on the impact of the stress scenario employed by the ECB and by Acharya and Steffen (2014a,b,c) instead of the capital shortfall, which is also affected the by choice of threshold for adequate capitalization. Authors normalise the dollar amount of stress impact by a common notion of firm exposure to make the comparison across banks meaningful. 

The  findings  suggest  a  nearly  mechanical  relationship  between  SRISK  stress  impact  and  market leverage ratio, which can also be explained by decomposing the analytical formula for SRISK stress impact appropriately. If heterogeneity in market leverage ratio is large, this is likely to dominate the heterogeneity in covariance of bank stock returns with the market index, and the market leverage becomes  the  driving  factor  behind  the  SRISK  stress  impact. This explains, why SRISK and ECB stress test results diverge in particular for banks that are close to bankruptcy and highly capitalised banks, which points towards another problem of the SRISK’s usage as a benchmark for stress tests, namely its focus on equity holders. SRISK is set up to model returns to equity holders; therefore the stress impact is bounded by the amount of equity. This is particularly worrying for banks that are initially insufficiently capitalised, where the limit on losses is most likely binding in a stress scenario.

Authors show that this has important practical implications, namely SRISK stress impact is only a tiny fraction of the size of the ECB/EBA stress impact for the least well capitalised banks.

Therefore authors conclude that SRISK is unsuitable as benchmark for macro-prudential stress tests. The question which leverage ratio or which threshold to use can be treated independently of the question which stress model to use. While not addressing the first question and not definitely answering the second question, their findings cast doubt on the usefulness of SRISK as a benchmark for supervisory stress tests.

Full working paper

© ECB - European Central Bank