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As ECB Takes Over Eurozone Supervision, Banks Must Get Better at Stress-testing Themselves

by Nancy Masschelein, Vice President, Market Management, Finance and Financial Risk at Wolters Kluwer Financial Services

Just over a week ago, all eyes were on results of the European Central Bank’s banking stress tests. The ECB had staked its reputation on delivering an independent assessment of eurozone banks before taking over as their supervisor on November 4. Now the day has dawned, what can the stress tests teach us about how the ECB will discharge this significant responsibility?

The ECB needed to understand the quality of the banks’ balance sheet, and to assert its credibility for its new role by conducting tough stress tests – the tests were said to be the toughest yet imposed on Eurozone banks. The adverse scenarios they had to hypothetically withstand included a slump in global debt markets, a rise in funding costs, recession, and plummeting property and equity prices. The ECB could not risk a repeat of the tests in 2011, when only nine banks failed, excluding Dexia – which collapsed shortly afterwards.

Some 20% of the 123 financial institutions assessed failed the tests. Of those, 13 banks will still need to restructure heavily or increase their capital. The total capital shortfall was €25 billion – rather sobering, considering that many banks have spent the last five years working to improve their capital position. The ECB showed it wants to create a level playing field for banks, with clear, consistent criteria and increased transparency. It’s good news for all of us that the ECB is forcing banks to think about stress scenarios in a more harmonized way.

Banks are still very uncertain, however, about how much and what information the ECB will demand in future. ECB’s Supervisory Council President Daniele Nouy has said the ECB does not only look at quantitative factors to assess banks’ resilience, but also at qualitative factors, such as the strength of banks’ IT and software. The only certainty is that banks will face growing information requests from the ECB.

Going into 2015, the whole process will be much more formalized. Banks will need good internal procedures and processes to cope with the requirements, especially as they are expected to change over time. In other words, the banks need to get better at stress-testing themselves. They must adopt a policy of ongoing self-testing to cope with the new ECB regime, testing themselves against scenarios that are specific to their business and circumstances. They need to implement a robust risk framework and run regular stress scenarios on their risk portfolios. Not all banks yet do that sufficiently.

Given the short time frame for this year’s test and host of other regulatory requirements in place, many banks addressed the requirements at least partially with tactical solutions, such as technical workarounds to help compensate a lack of data. That approach might have been adequate for the short term, but stress will recur annually and become more complicated over time. So banks will need to address the requirements more strategically and in a less resource-heavy way in the years ahead.

It’s also important that the ECB itself constantly updates and re-assesses its testing criteria. Geopolitical events, such as the Russia/Ukraine situation, weren’t accounted for in this year’s tests. However robust the ECB processes are, there will always be ‘black swans’ and the whole sector needs to remain vigilant.

So this year’s tests were only the beginning. Stress testing must now become a continuous, and regularly updated, exercise – performed both by banks themselves and by their new supervisor.