Last Wednesday, the European Banking Authority (EBA) began the process of stress testing Europe’s largest banks in an effort to assess their individual capital adequacy under stressed conditions. The publication of a draft stress test methodology coincided with the announcement of the resolution of Spain’s Banco Popular Espanol, a bank that fared relatively well in the 2016 stress test results published 10 months ago.
The draft stress test methodology and the timing of its publication convey two key messages for European Union (EU) banks andinvestors. First, the stress test for 2017-18 will be tougher, given that it will include the new accounting rule known as International Financial Reporting Standard (IFRS) No. 9, which requires that banks set aside provisions on all loans in advance of default. Second, notwithstanding EU supervisors’ efforts to harmonise rules and enhance stress testing, Banco Popular’s failure has revealed once more the principal limitations of stress testing in signalling potential failures, which has resulted in scepticism toward the exercise.
The 2018 stress test will once again look at the effect of macroeconomic stress on a bank’s viability, taking into account market risk and litigation risk. Additionally, the test will include simulations of risk charges under IFRS 9 of expected credit losses. IFRS 9 addresses the issue of loan-loss provisions being “too little and too late,” something regulators identified as a shortcoming that amplified the 2007-09 banking crisis. The accounting change will require banks to model credit risk losses for loans even before they have defaulted, and increase the level of provisions as they start to deteriorate.
Considering that banks must use IFRS 9 starting in January 2018, the inclusion of the new rule in the next stress test is not surprising. However, its potential effect on banks’ capital in the stress test is opaque given the difficulty in estimating stressed simulated risk provisions that must be based on a new accounting concept ahead of its implementation deadline. However, incremental risk provisioning under IFRS 9 will focus on loans that show deterioration in borrowers’ credit quality since inception of the loan. Therefore, we expect banks that are challenged by low growth and persistent asset quality pressures will be more affected. Although the stress test again will not involve a pass-or-fail decision benchmarked against a hurdle rate, the 2018 stress test is still likely to force some banks to hold more capital.
With the resolution of Banco Popular, whose subordinated creditors were bailed-in and their investment effectively wiped out, we expect that the EBA’s 2018 stress test again will single out weak candidates, but the results still may not reliably predict the next failure. Although the 2016 stress test formally identified Banco Popular as the weakest among the six participating Spanish banks, it was by no means among the most vulnerable candidate when taking into account a capital measure undertaken shortly after the year-end 2015 cut-off date for the test. The bank reported a relatively weak common equity Tier 1 ratio of 7.0% in the adverse scenario, but, adjusted for a €2.5 billion rights issue that had been concluded by the time the results were published, the bank’s result ranked second-best in the Spanish peer group, with a solid 10% pro forma result.
