18 June 2018

European Parliament: How demanding and consistent is the 2018 stress test design in comparison to previous exercises?

In January 2018, the EBA launched details regarding the 2018 EU-wide stress test. This paper discusses details of the macro-financial scenario published by the ESRB and in the EBA/ECB methodology, as well as the translation of this adverse scenario to the market risk scenario.

The following conclusions can be drawn:

• Main characteristics of the ESRB scenario: The adverse scenario constitutes the most severe scenario compared to previous EU stress tests (the deviation of the baseline EU growth rate is more than 8 pp in 2020). The adverse shock most likely originates in the US and transmits to Europe via an increase in risk premia. The country-specific calibration implies a highly asymmetric impact of the scenario: countries with a high degree of trade opened seem to be more affected compared to countries with lower openness.
• Plausibility of the ESRB scenario: While it is difficult to foresee what kind of future macroeconomic crisis will emerge, it can be questioned whether a foreign shock originating in the US really constitutes the most relevant risk to the European banking sector. Further, authors identify some seemingly implausible country-specific adjustments of macro variables following the adverse shock
• Forecast of banks’ loan losses under the 2018 stress scenario: Applying a methodology from Niepmann and Stebunovs (2018), we forecast the impact of the 2018 adverse scenario on banks’ credit losses. Based on the assumption that banks’ internal forecast models have not been changed since 2016, authors conclude that the 2018 stress test will presumably lead to lower losses compared to the 2016 stress test.

The EBA does not publish its benchmark risk parameters regarding the translation of the scenario to credit risk. These risk parameters are only provided to banks. This lack of transparency makes it impossible for the public to assess the severity of the stress scenario and weakens the credibility of the EU-wide stress test exercise. A redesign of the stress test that focusses on the information requirements of market participants could improve the effectiveness of the stress test in in supporting market discipline among European banks.

• Translation of the ESRB scenario to the market risk scenario: Authors identify several inconsistencies when comparing the calibration of the ESRB adverse scenario with the EBA/ECB market risk scenario. These inconsistencies are possibly the result of political bargaining between regulators from different countries to soften the calibration of the stress test.
• The 2018 stress test introduces some methodological changes, the most important of these being the introduction of IFRS 9. However, the EU transitional arrangements allow banks to completely neutralize all IFRS 9 impacts and even alleviate the severity of the stress test.

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