EU And US Bank Stress Tests Move In Different Directions
Tuesday, March 22, 2011

While the European Banking Authority (EBA) has published documents explaining the stricter scenarios and methodology for its 2011 bank stress test, and the UK Financial Services Authority Chairman Lord Adair Turner is looking for even more stringent rules, the US Federal Reserve is relaxing its restrictions on its biggest banks.

The European Union (EU) stress test, which will be applied on a wide sample of banks covering over 60% of total EU banking assets, is a supervisory tool designed to assess the resilience of European banks to hypothetical external shocks. A stress test is supposed to assess what might happen to banks if external circumstances deteriorate markedly, and to help identify vulnerabilities and relevant remedial action, including strengthening capital levels where this is needed.

The documents issued by the EBA contain information on the macro-economic scenarios and the methodologies that are used to assess the impact changes in the economic environment have on banks. The adverse scenario is more severe than the 2010 Committee of European Banking Supervisors’ exercise. It includes a marked deterioration in the main macro-economic variables from the baseline forecast - such as gross domestic product (which falls 4% from the baseline compared to 3% in the 2010 exercise), unemployment and house prices.

The adverse scenario also includes a specific sovereign stress in the EU leading to further falls in the price of some EU bonds from the already stressed levels seen at end-2010. The sovereign haircuts will apply to positions in the trading book where losses would materialise, and will be accompanied by full disclosure of all relevant sovereign debt holdings.

The methodologies and assumptions are designed to ensure the stress is applied consistently across all the banks in the exercise. In particular, the static balance sheet assumption freezes banks’ balance sheets of end 2010. This ensures consistency and prevents banks from claiming they would change their business model or sell off risky assets to mitigate the risk.

Although there has been no disclosure of the minimum core capital threshold that banks would be expected to surmount, the EBA has recognised the need to run a credible test and the threshold is expected to be higher than in 2010, when the tests were criticised as being too easy.

The exercise is being run between March and June 2011, and its results will be published on a bank-by-bank basis in mid-June. It is being coordinated with the national supervisory authorities, the European Systemic Risk Board, the European Central Bank and the European Commission.

Lord Turner, while he was attending the publication of the FSA’s Prudential Risk Outlook, said that it was “vital that banks focus on achieving further progress to sound funding positions, maintain high capital ratios and adequate provisions.” In particular, UK banks will be subject to a harsher stress test which would consider “a range of policy options in the euro-zone peripheral countries, including a prolonged period of austerity and possible restructuring of bank and sovereign debt.”

However, at the same time, US Federal Reserve announced that it has completed the Comprehensive Capital Analysis and Review, its cross-institution study of the capital plans of the 19 largest US bank holding companies, and that, as a result, some financial institutions are being allowed to increase or restart dividend payments, buy back shares, or repay government capital.

In February 2009, the Federal Reserve advised bank holding companies that safety and soundness considerations required that dividends be substantially reduced or eliminated. Since that time, it has also indicated that increased capital distributions would generally not be considered prudent in the absence of a well-developed capital plan and a capital position that would remain strong even under adverse conditions.

It was said that the Federal Reserve's actions on capital distributions come “after significant improvement in both economic conditions and the capital positions of US financial institutions.” From the end of 2008 through 2010, common equity has increased by more than USD300bn at those 19 US bank holding companies.

The banks’ new capital plan, the Federal Reserve added, proposes “appropriate capital distributions in a measured fashion while still helping to ensure continued increases in firms' capital bases.” Banks are expected to demonstrate their ability to remain viable financial intermediaries as they make the planned capital distributions, even under stressed conditions. They are expected to continue to increase their capital base; and, in 2011, are generally are expected to limit dividends to 30% or less of anticipated earnings.