This year’s EU-wide Stress Test is well underway. COVID-19 means that the process poses new operational challenges and more severe macroeconomic scenarios than in previous years. The result is likely to be greater average levels of CET1 depletion. Banks also need to prepare for a more demanding future, with 2022 bringing a supervisory stress test on climate-related risks and 2023 a potential new format for the next EU-wide stress test.

2021’s EU-wide Stress Test, postponed from 2020 due to COVID-19, is now in full swing. The exercise began in January with the publication of the test’s macroeconomic scenarios, and results will be published by the end of July. This year’s exercise will be particularly important in assessing banks’ resilience and ability to withstand further shocks while continuing to finance the real economy.

Similar… but different

As in prior years, the current exercise has two related elements: the EBA’s EU-wide stress test of approximately 50 leading banks, and the ECB’s SSM stress test for significant institutions not covered by the EBA’s test. The two regimes are closely aligned and follow similar methodologies to the stress tests of 2018.

In other respects, however, the current tests are more challenging than their predecessors. The macroeconomic scenarios are – as might be expected – more severe than in prior years. And while the test is not a pass or fail exercise, its results carry increasing weight. The quantitative and qualitative outcomes of the 2021 test will inform the next SREP and supervisory planning for on-site inspections and other inquiries, as seen in previous years. For instance, the timeliness, accuracy and quality of banks’ data submissions will have an impact on determinations of Pillar II Requirements (P2R). In addition, the capital depletion that results from the adverse scenario over a three-year horizon will help to determine banks’ Pillar II Guidance (P2G).

Banks face significant challenges

These challenges mean that banks, which have often viewed stress tests as an unrealistic compliance exercise, see 2021’s exercise as increasingly relevant for their risk appetite definition, ICAAPs and capital planning. In response, banks’ boards and executive directors are committing increasing attention and resources to stress testing, and to building up their capabilities and processes in this area. Discussions with banks lead us to believe that many carried out significant remedial or preparatory work before 2021’s exercise, whether by improving their technology and data systems or by addressing lessons learned from previous tests. Banks participating in the tests for the first time seem to have found internal dry-runs particularly useful.

Even so, banks face some significant challenges as they carry out the current stress test:

  • Timing. Due to current circumstances, banks are already under pressure to fulfil supervisory reporting requirements such as FINREP, COREP and Capital Adequacy Statement as well as Liquidity Adequacy Statement, not to mention additional COVID-19 related reporting.
  • Data quality. Although the stress test methodology has not changed hugely, data templates and assumptions continue to evolve, requiring banks to revisit and check their data gathering processes – for example, by verifying that COREP and risk management data are consistent.
  • Judgements. Despite their increasingly prescriptive methodology, the stress tests still allow substantial scope for banks to adjust their outcomes. This poses a double risk for banks, since overestimating vulnerability will increase their capital requirements, while too much optimism could lead to supervisory intervention.

First insights into 2021’s results

European banks have now provided supervisors with their first full data submissions, including their stressed projections. So far, a number of factors suggest that 2021’s stress test results will show a greater depletion in CET1 capital than in previous years. On one hand, these include the features of adverse scenarios:

  • The severity of the prolonged COVID-19 scenario in a ‘lower for longer’ interest rate environment, which is expected to have a negative impact on net interest income results, especially for banks with significant carry and maturity transformation.
  • The impact of adverse economic shocks, including higher unemployment rates, on retail banks’ credit risk results. This is expected to be particularly severe in southern European countries.
  • The effects of severe equity valuation adjustments over the time horizon of the test on the financial assets of banks, especially those with large trading books.

In addition, other factors inherent in the stress test methodology are likely to have an impact on the results of the 2021 stress test. Key constraints such as the ‘zero-floor’ for retail deposits over the time horizon of the test, and assumptions such as the static balance sheet, do not allow for a realistic simulation of how banks would respond to additional stress. The fact that 2020 year-end balance sheets will be the starting point for banks’ tests will also influence the results.

Taken together, these factors are likely to contribute to negative stress test results, and we expect average levels of CET1 depletion to exceed those seen in previous exercises. It’s also worth remembering that banks’ projections can be overridden by supervisors, based on peer benchmarking or top-down modelling, during the dialogue phase of the exercise.

Where do we go from here?

The current stress test is particularly demanding in operational terms. Conservative assumptions and scenarios also mean that it’s likely to have more negative results than in prior years. Looking ahead, the next few months will not only bring the publication of the current stress test results. Banks can also expect some clarification about the shape of future stress tests. The ECB’s climate-related stress tests in 2022 is approaching fast and will be followed rapidly by the next EU-wide stress test in 2023. As highlighted in our previous article, the latter is currently expected to follow a new, more demanding format involving two formal elements (bottom-up and top-down).

In short, banks’ challenges from stress testing will not end in July 2021. Banks need to ensure that they have the data management and oversight capabilities in place to prepare for a more demanding regime in future.