29 October 2019

ECB: The disciplining effect of supervisory scrutiny on banks’ risk-taking: evidence from the EU‑wide stress test

This article aims to contribute to the ongoing discussion about the long-term strategy for stress testing in the euro area. In particular, it highlights some of the strengths and weaknesses of the constrained bottom-up approach, which is currently used in the EU‑wide stress-testing exercise.

Under this approach, banks use their own models to generate stress test projections on the basis of a common macroeconomic scenario and under the constraints imposed by the European Banking Authority methodology. This set-up provides banks with some scope to underestimate their vulnerabilities in order to appear more resilient than their peers.

This article confirms previous empirical evidence showing that such behaviour may indeed be practised by banks. This, in turn, requires a robust quality assurance of banks’ stress test projections by the competent authorities (including the European Central Bank), to enforce more realistic results. Against this background, the article presents a novel empirical analysis providing indicative evidence that the “supervisory scrutiny” relating to the quality assurance may be having a disciplining effect on banks’ risk-taking.

This article has highlighted certain strengths and weaknesses of the current constrained bottom-up approach of the EU‑wide supervisory stress tests.

On the one hand, the bottom-up nature of the exercise provides banks with leeway and incentives to underestimate their vulnerabilities in order to appear better than their peers. On the other hand, the stress tests are conducted applying a robust quality assurance of banks’ stress test submissions by competent authorities (including the ECB), which ensures the credibility and reliability of the results and may have beneficial disciplining effects on stress tested banks’ risk-taking. This analysis has provided empirical evidence both of the possibility that banks “game” the stress-testing exercise and of the possible disciplining effects of the supervisory scrutiny that is entailed by the quality assurance process. These findings may be relevant for ongoing discussions about the long-term strategy for the European banking sector stress tests.

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