We are moving closer to the 2016 EU-wide stress testing process, an assessment that seeks to test the resilience of financial institutions under extreme situations. Can banks cope with a new economic crisis? Stress tests provide the answer. Here are the keys to understand what they will be like.

What are the bank stress tests?

They are a series of tests that assess the resilience of financial institutions to adverse macroeconomic developments. After the 2007 international financial crisis, they have become an essential oversight tool.

Stress tests serve a double purpose:

  1. Assess and value a bank’s capacity to absorb losses (resilience).
  2. Build trust in the banking sector and provide an information tool for investors, analysts and other participants in the financial markets. To achieve this second objective, each institution’s results are published, on a separate basis.

When did the bank stress tests start in Europe?

There have been EU-wide stress testing rounds in 2009, 2010, 2011 and 2014. The last stress testing round, in 2014 focused mainly on a series of common risks, including credit, market and sovereign risks, as well as the impact on P&L accounts and capital.

Based on the consolidated data of the institutions as at December 2013, and under the assumption of a static balance sheet, the impacts for the 2014-2016 time horizon were calculated, in compliance with two scenarios:

  • A baseline scenario, elaborated building on the European Commission’s macroeconomic forecasts
  • The adverse scenario, which took into account negative impacts for the economy.

A series of minimal capital thresholds were established, which companies were required to meet (8% CET1 in the baseline scenario and 5.5% CET1 in the adverse scenario).

What were the results?

Out of the 123 institutions examined, only 25 failed to pass the tests, with a capital deficit of almost €25 billion. These institutions were given 9 months to submit plans to cover their identified capital gaps.

This exercise was the second part of the Comprehensive Assessment carried out by the ECB in 2014, whose first part consisted in a detailed Asset Quality Review (AQR).

What were BBVA’s results like?  1) BBVA demonstrated its resilience capacity, obtaining the lowest difference between its CET1 capital ratio in the baseline and adverse scenarios in the 2016 horizon of all the large European institutions tested. Likewise, it was proven to be one of the few institutions capable of generating profits and paying dividends, even in the adverse scenario. 2) The 9.0% CET1 phased-in ratio obtained in the adverse scenario as at December 2016 equated to exceeding the minimum (5.5%) by more than €13.2 million. 3) The fully loaded CET1 ratio as at 2016 in the adverse scenario for BBVA stood at 8.2%. Only two other more large European banks exceeded the 8% threshold.

What will the 2016 tests be like?

The European Banking Authority (EBA) published on November 5th its 2016 EU-wide stress test draft methodology and templates.

53 banks will participate in the exercise, covering broadly 70% of the EU banking sector’s assets. Out of the 53, 39 fall under the jurisdiction of the Single Supervisory Mechanism (SSM), the new EU-wide banking oversight system integrated by the ECB and the supervisory authorities of the participating EU countries.

What Spanish banks will be taking part?

Six Spanish institutions will be assessed. Santander, BBVA, CaixaBank, Bankia, Popular and Sabadell.

Spain will be the second country, with France, by number of banks tested, after Germany, with 10 banks taking part in the tests. Italy stands next, with 5 institutions tested, followed by the Netherlands, UK and Sweden, each with four.

For the rest of large institutions not covered by EBA tests, the ECB will probably conduct its own stress tests in parallel, with a methodology consistent with the EBAs, although taking into account the smaller size and complexity of these institutions.

What are the goals?

One of the key goals of the tests is to assess the resilience of the banking system to shocks. In this occasion, the tests incorporate another key objective: Offer a common analytical framework to supervisors, banks and other participants, providing a consistent basis for comparison.

These tests will, once again, assess bank resilience under two common macroeconomic scenarios – one baseline and one adverse – based on the consolidated data of the institutions as at the end of 2015. These scenarios will be applied over a three year time horizon. Just as in the previous one, this round of stress-testing will be carried out under the assumption of a static balance sheet, and banks will have to project the effect following the methodology established for a common series of risks: Credit risk (including securitization), market risk, credit counterparty credit risk and operational risk, as well as to plan the effect of the scenarios in the P&L account and other capital items.

What new features do the tests include this year?

One of the key new features is the inclusion, within operational risk, of the assessment of the risks related to commercial practices, and, in credit risk, the eventual higher risk from loans denominated in different currencies.

As regards the main differences with previous exercises, no capital thresholds are defined. Instead, the results will be integrated in the Supervisory Review and Evaluation Process (SREP), in a way such that they will be used to calculate Pillar 2 capital needs of credit institutions on an individual basis.

On the other hand, and although the sample of banks included in the EBA’s stress test is considerably smaller compared to the previous one (53 vs. 123), tested institutions will be required to provide more extensive and detailed information than in 2014, as one of the essential reasons for reducing the sample was to conduct a more comprehensive and demanding assessment.

When will the stress tests be conducted?

The stress tests are scheduled to begin by late February 2016, with the disclosure of the methodology, templates and final scenarios by the EBA. Year-end results, including individual results of the institutions, should be ready by the beginning of the third quarter of 2016.

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