October 2024
The EBA starts the race
The 2025 stress test cycle has officially begun. On 5 July the European Banking Authority (EBA) released its draft methodology and templates for consultation. The EBA aims to finalise these by the end of the year following industry comments, before starting the stress test itself in January. The EBA has announced that the stress test will cover 68 banks from the European Union (EU) and Norway, including 54 from the euro area. The ECB will then extend the stress test to all ‘significant institutions’ (SIs) under its supervision (with some adjustment for smaller banks in the name of proportionality).
As we have previously written, the new stress test methodology represents an evolution, not a revolution, from previous exercises. The principal innovation is requiring banks to calculate their risk-weighted assets (RWAs) and capital ratios according to the new rules set out in the third EU capital requirements regulation (CRR 3), which became law this summer and will take effect from 1 January 2025.
The ECB is now a key player…
The European Central Bank (ECB) will play a key role in the 2025 stress test, including by scrutinizing the returns from SIs within the euro area. The stress test results will then be a key input into the capital, liquidity and governance/risk management elements of the 2025 Supervisory Review and Evaluation Process (SREP).
…With an increasing focus on stress tests
Indeed, in recent years stress tests have played an increasingly important part in the ECB’s overall supervisory approach. Since 2021 the ECB has used the degree of capital depletion identified by the stress test as the starting point for setting Pillar 2 capital guidance (P2G) under a ‘bucketing’ approach.
This growing importance of stress testing within ECB supervision looks set to the continue. The ECB’s Supervisory Board Chair Claudia Buch has spoken several times this year about the uncertainties — macroeconomic, geopolitical and environmental – facing European banks. In this context, she has advocated greater use of forward-looking risk assessment tools, such as stress tests. And the ECB has made use of stress tests to evaluate some of the emerging risks Buch identified: at the start of this year the ECB conducted its first cyber resilience stress test, assessing banks’ ability to respond to a severe cyber-attack.
The significance of stress tests was given a further boost by the ECB’s decision to include stress test returns within the scope of its risk data aggregation and risk reporting (RDARR) requirements. The ECB’s latest RDARR Guide, released in May, specified for the first time that data compiled for stress tests must meet the Basel Committee on Banking Supervision’s (BCBS) 239 standards. Banks preparing for stress tests must therefore ensure their data governance and data lineage frameworks are robust. Stress test returns could themselves also be examined by the ECB as part of their ongoing campaign of BCBS 239 on-site inspections.
Getting ready for the stress test
The growing importance of stress testing underlines the need for banks to prepare thoroughly for the upcoming exercise. Three key areas of focus should be:
The launch of the 2025 stress test is now only a few months away. In our view, the more that banks can use that time to prepare, the better placed they will be for success in an increasingly crucial supervisory exercise.