Internal stress tests of EU banks not up to scratch – ECB

Only one in 10 banks’ internal tests are tougher than supervisor-run programmes

Banks’ homespun stress tests are not tough enough to suitably prepare them for real-world crises, the European Central Bank says. They also lack the scope and complexity to capture the range of threats they face.

Self-run stress tests produced an average maximum Common Equity Tier 1 (CET1) depletion of 3.3% across a sample of European banks, far lower than the 4.8% projected under the supervisor-run stress test of 2018. Only one in 10 banks ran tests that produced a greater capital ‘burn’ than the supervisory test.

The ECB also found that few banks used the findings of internal stress tests to devise management actions that could be used in a real crisis to preserve capital.

 

In addition, the agency discovered that banks most commonly use two adverse scenarios for their internal stress-testing programmes under the ‘normative perspective’ and two or fewer under the ‘economic perspective’. The former refers to tests run to gauge compliance with supervisory requirements, the latter to those designed to measure resilience to all material risks. 

Under the normative perspective, 43% of banks conducted stress tests more frequently than annually, compared with 58% under the economic perspective.

Roughly half of the banks surveyed had no documented process for running ad hoc stress tests outside their regular cycle.

What is it?

Banks are required to maintain “sound, effective and comprehensive strategies” to asses the amount, type and distribution of internal capital they need to cover their risk exposures under the EU’s Capital Requirements Directive.

Each firm’s internal capital adequacy assessment process (Icaap) is used by the EU’s Single Supervisory Mechanism (SSM) as an input to its own Supervisory Review and Evaluation Process (SREP), which determines Pillar 2 capital requirements.

The ECB survey of Icaap practices encompassed 37 significant institutions covered by the SSM, and was conducted on Icaap submissions made in April 2019.

Why it matters

Slipshod internal stress-testing programmes leave banks unprepared to deal with sudden shocks, such as the coronavirus crisis. The ECB said it was particularly concerned that insufficiently stressful scenarios, an absence of ad hoc stress-testing capabilities and a failure to put in place management action strategies based on test outcomes put lenders at risk of succumbing to financial calamity.

One way to improve practices, the ECB suggested, would be for banks to embed their internal stress-testing programmes within their risk functions, rather than considering testing simply as an annual chore to be left to their finance departments. 

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