The EBA - Stress test 2025 at a glance

The European Banking Authority (EBA) published the draft rules for the EBA Stress Test 2025 on 5 July 2024. This is the starting signal for banks to prepare for this. The supervisory authority will discuss the draft in workshops with representatives of the banks and is expected to publish a final version at the end of the year. However, the most important further developments and innovations can already be derived from the drafts.

Thorough preparation for the EBA stress test 2025 is essential for banks in order to fulfil the regulatory requirements. Find out below which changes banks need to be prepared for, what will be particularly important in the EBA stress test in 2025 and which topics should be tackled first in preparation.

EBA stress test 2025 marks switch to the CRR3 regime

As in previous years, the EBA publishes a draft for the dialogue with the banking sector in the summer before the stress test is carried out. The final specifications are expected at the end of 2024. However, banks should already anticipate the most important changes on the basis of the draft methodology and templates and begin preparations. Because the last few years have shown: After the first draft of the stress test, the EBA still adjusts fine details and corrects errors. However, there have never been any fundamental changes to the EBA's first draft in the final versions, and they are not to be expected this time either.

With its draft, the EBA has built on the requirements of previous years, reviewed weaknesses and, as in the last stress tests, also aimed for continuous further development towards greater transparency for the supervisory authorities. For banks, this often leads to increasing data requirements with simultaneously decreasing degrees of freedom.

The central innovation of the 2025 stress test is the inclusion of the third Capital Requirements Regulation (CRR3), which will apply from 1 January 2025. The new requirements for calculating risk-weighted assets (RWA) for credit risk, credit valuation adjustment (CVA) and operational risks must be integrated into the projections from the starting point. The decision to postpone the Fundamental Review of the Trading Book (FRTB) in the EU is also taken into account in the EBA stress test. The calculation of capital requirements for market risks is still based on the CRR2 rules. At the same time, the output floor is being introduced, which requires a second calculation for the internal models in the standardised approach (SA). Only in the FRTB-SA and the SA for operational risks are the calculations of the output floor limited to the starting point, while a complete RWA simulation of the internal ratings-based (IRB) portfolios in the standardised approach (SACR) is required for credit risk in particular. This is a significant cost driver for IRB banks with a potential impact on results.

Read below to find out how the entry into force of CRR3 with the shift of the FRTB affects credit and market risk, what role the additional requirements of market price risk and the centralisation of net interest income (NII) play and what effects the additional proportionality has.

The application of CRR3 represents the most important change in credit risk. The figures for risk provisioning and RWA must be reported both at the starting point and in the projections in accordance with the requirements of CRR3. In the RWA calculation, CRR3 with its credit risk components, such as the adjustment of risk weights in the CRSA, has a direct impact on the result. The newly introduced output floor in particular means additional operating expenses for IRB institutions, as the RWA must also be simulated for IRB portfolios in accordance with CRSA and entered in a separate template. This output floor can have a material effect on earnings for IRB institutions in the simulation of RWA. In addition to the application of CRR3, the non-performing loans template will also be expanded to include forbearance information to be reported. Furthermore, the EBA specifies the requirements with regard to the projection of risk provisioning at the level of economic sectors - in particular, the design of a loss distribution approach in the absence of sector-specific credit risk models is addressed.

In addition to the effects of CRR and FRTB, the requirements for market risk have been expanded overall. The full reval template now requires a breakdown by issuer or borrower class and a significantly refined breakdown of hedge relationships, which replaces the previous long/short presentation and is very similar to the requirements of the ad hoc data collection on bond positions in 2023. The proportionality classes have been revised, with the definition of TE / CA changed and a new CA Advanced class introduced. Banks assigned to the new CA Advanced class have to fill an additional offshoot of the Full Reval Template, which shows the effect of six different scalings (100 per cent, 80 per cent, ..., -20 per cent) of the EBA stress scenario on options and their hedges in the trading portfolio. The stressed projection of SA-CVA and BA-CVA is now required for all CA and CA-adv banks. In addition to CVAs, the template for valuation reserves now also includes funding valuation adjustments (FVAs) including sensitivities. Additional losses arise in counterparty risk due to the default of three instead of two counterparties. Overall, the expenses for filling the templates in particular are significantly increased in market risk.

Following the steady trend towards standardisation, the NII will now provide a central approach for projections by the supervisory authority. Implementation is not yet included in the published drafts, but methodologically this will be derived from the formulas for intertemporal consistency, which must be adhered to since 2020. Banks can only make their own projections for the margins of derivatives. Funding matches, for example for promotional loans, are now reported and simulated separately in order to mitigate the one-sided effect of the idiosyncratic shock on liabilities.

A long-standing point of criticism from banks was the inclusion of trading book positions in net interest income, which also led to some implausible results in the 2023 EBA stress test due to the rise in interest rates. The supervisory authority has now reacted: Instruments with trading intent are largely excluded from the NII simulations and instead the average interest contribution of recent years is extrapolated.

The introduction of CRR3 represents a significant change in operational risk. RWA must be reported as at the reporting date in accordance with both CRR2 and CRR3. For the projection, the RWA are kept constant at the CRR3 value. If banks apply the alternative standardised approach in accordance with CRR3 Article 314 (2a and 2b), they must also report transitional capital requirements. In addition, the new CRR3 business indicator approach must be calculated at the starting point.

Another key aspect of the new methodology is the adjustment of the multipliers for calculating the floors for the projection. The floor for material behavioural risks is raised, while the floor for non-material and other operational risks is lowered.

The EBA cites the extension of the proportionality principle to smaller banks with total assets of less than EUR 50 billion as a key further development. This was previously reserved primarily for ECB-supervised banks outside the EBA group of participants. In practice, the simplifications are manageable. In particular, the number of country-currency pairs in reporting can be reduced. On the other side of proportionality, the EBA is introducing the Comprehensive Approach Advanced for banks with material market risk exposure (market risk RWA > 8 per cent of total RWA), which further tightens the requirements.

Procedure and schedule

The EBA has announced that it will publish the final requirements at the end of 2024 and the results of the stress test in July 2025. It can therefore be assumed that the timetable will be similar to previous years. In the first quarter of 2025 in particular, there will be phases of high stress with the submission of the starting point at the beginning of March and the submission of the complete templates at the beginning of April, as this will take place in parallel with the annual financial statements and the preparation of the first COREP report in accordance with CRR3. Banks should prepare well for this phase and plan sufficient resources.

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What banks should do now

CRR3 implementation required for the success of the stress test

The integration of CRR3 into the starting point and projections is the biggest challenge for banks in the 2025 stress test, particularly for IRB banks, for which a double calculation of the portfolios is required. While an initial cut-off date analysis of the CRR3 RWA requirements including the output floor is only required by regulation for 31 March 2025, the EBA stress test already anticipates this for 31 December 2024, extended by the projection over three years.

Banks should therefore promptly link the preparation of the EBA stress test 2025 with the ongoing work on CRR3. The simulation of the IRB and SA portfolios over time, which is necessary for IRB banks, and the calculation of the capital requirements for CVA, FRTB-SA and OpRisk for all banks will take centre stage. In view of the results, planned optimisation measures for CRR3 should also be implemented by the reporting date of 31 December 2024 if possible, so that they can already take effect in the stress test.

Data quality as a key success factor for the EBA stress test

As part of EBA stress test exercises, banks must collate a lot of data, ensure consistency and report this to the supervisory authority. The implementation of the new methodology - also outside of the CRR - requires careful and early identification of additional data requirements. This applies in particular to the reporting of market risk. The extensive data queries on hedge accounting from 2023, which run parallel to the stress test, were integrated into the EBA stress test and require a precise link between hedged items and hedging transactions. Banks should also promptly check whether they currently or prospectively fall under the newly introduced Advanced Comprehensive Approach to market risk, which greatly expands the requirements of the previous Comprehensive Approach, and implement the additional requirements.

Prepare a smooth process

Once again this year, well-organised internal coordination and the provision of essential resources and data will be crucial. The creation of a detailed runbook adapted to the updated requirements and processes is a great advantage for the actual stress test implementation. Banks should also check how the dependency on the centralised NII calculation affects the overall process. Implementation of the calculation is not included in the current draft template and could possibly only be made available in February 2025, analogous to the ECB's Credit Risk Path Generator - or even after the starting point has been submitted. Alternative options for estimating and checking the plausibility of the NII results should therefore be prepared at an early stage.

The EBA stress test 2025 from the banks' perspective: CRR3 as a major challenge and only a little more time to overcome it.

Tim Breitenstein

Director, Financial Services

KPMG AG Wirtschaftsprüfungsgesellschaft

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