EU-wide Stress Test Research Articles

Decoding market reactions: The certification role of EU-wide stress tests

We study the market’s reaction to the disclosure of EU-wide stress test results across four periods (2014, 2016, 2018, and 2021). Our novel approach contributes to the literature by studying how stress test disclosures influence both the mean and variance (first and second moments) of bank stock performance, extending beyond previous studies focused mainly on the first moment of equity returns. Using one-factor market and structural Engle–Siriwardane type GARCH models, we find that the publication of stress tests provides new information to the markets: Banks with weaker performance in the tests experience, on average, a reduction in stock returns and an increase in volatility, while the reverse holds for banks performing well. Our findings confirm the important role of stress tests in enhancing transparency and market discipline, thereby supporting investors in assessing the resilience of the banking sector more effectively, particularly during periods of higher uncertainty.

On the key drivers of capital depletion in the EU-wide stress tests

On the key drivers of capital depletion in the EU-wide stress tests

A Review of the Discussion Proposal on Changes to the EU-wide Stress Test

A Review of the Discussion Proposal on Changes to the EU-wide Stress Test

The disciplining effect of supervisory scrutiny in the EU-wide stress test

Relying on confidential supervisory data related to the 2016 EU-wide stress test, this paper presents novel empirical evidence that supervisory scrutiny associated to stress testing has a disciplining effect on bank risk. We find that banks that participated in the 2016 EU-wide stress test subsequently reduced their credit risk relative to banks that were not part of this exercise. Relying on new metrics for supervisory scrutiny that measure the quantity, potential impact, and duration of interactions between banks and supervisors during the stress test, we find that the disciplining effect is stronger for banks subject to more intrusive supervisory scrutiny during the exercise. We also find that a strong risk management culture is a prerequisite for the supervisory scrutiny to be effective. Finally, we show that a similar disciplining effect is not exerted neither by higher capital charges nor by more transparency and related market discipline induced by the stress test.

The Disciplining Effect of Supervisory Scrutiny in the EU-Wide Stress Test

The Disciplining Effect of Supervisory Scrutiny in the EU-Wide Stress Test

Macro-stress testing dividend income. Evidence from euro area banks

This paper employs panel data methods to estimate a macro-financial model for dividend income for a sample of euro area banks, with results indicating that financial and macroeconomic variables help explain dividend income. Using the estimated parameters, the study conducts a scenario analysis projecting dividend income over a three-year horizon conditional on the baseline and adverse macroeconomic scenarios prepared for the 2020 EU-wide stress test. The resulting projections show that dividend income is markedly more conservative under the adverse scenario compared to the baseline scenario. This implies that it is important to take account of financial and macroeconomic variables when stress testing dividend income of banks. Relying on scenario-independent dividend income projections might lead to a misrepresentation of banking-sector soundness and resilience to shocks.

The Disciplining Effect of Supervisory Scrutiny in the EU-wide Stress Test

Using a difference-in-differences approach and relying on confidential supervisory data and an unique proprietary data set available at the European Central Bank related to the 2016 EU-wide stress test, this paper presents novel empirical evidence that supervisory scrutiny associated to stress testing has a disciplining effect on bank risk. We find that banks that participated in the 2016 EU-wide stress test subsequently reduced their credit risk relative to banks that were not part of this exercise. Relying on new metrics for supervisory scrutiny that measure the quantity, potential impact, and duration of interactions between banks and supervisors during the stress test, we find that the disciplining effect is stronger for banks subject to more intrusive supervisory scrutiny during the exercise.

On the informative value of the EU-wide stress tests and the determinants of banks’ stock return reactions

We examine the informative value of the 2016 and 2018 supervisory EU stress tests on the basis of bank stocks and Credit Default Swaps’ abnormal returns behavior. Our conclusions are based on results from an event study analysis and from regressions on the determinants of bank stocks’ abnormal returns. The robustness of our results is checked by applying our testing methodology on abnormal returns generated from both a single factor and a five factor Fama–French models. We conclude that the 2018 stress test has been comparatively more informative for investors but only for a sub-group of banks based on sovereign debt-ridden and non-Eurozone countries. The equity Tier I, leverage and profitability ratios are important determinants of abnormal bank stock returns but only for the same sub-group of banks. Non-linear reactions highlight the fact that investors assign varying degrees of importance on the information they get from the stress tested financial ratios. Overall, our results may substantiate an argument that the recent EU stress tests have been calibrated towards revealing the weaknesses of the banking sector of peripheral Eurozone and non-Eurozone countries.

Sensitivity of credit risk stress test results: Modelling issues with an application to Belgium

This paper assesses the sensitivity of solvency stress testing results to the choice of credit risk variable and level of data aggregation at which the stress test is conducted. In practice, both choices are often determined by technical considerations, such as data availability. Using data for the Belgian banking system, we find that the impact of a stress test on banks’ Tier 1 ratios can differ substantially depending on the credit risk variable considered, but much less so on the level of aggregation. If solvency stress tests are going to be used as a supervisory tool or to set regulatory capital requirements, there is a need to further harmonise their execution across institutions and supervisors in order to enhance comparability. This is certainly relevant in the context of the EU-wide stress tests, where institutions often use different credit risk variables (and levels of data aggregation) to estimate the impact of the common methodology and macroeconomic scenario on their capital level and supervisors rely on different models to quality assure and validate banks’ results. More generally, there is also a need to improve the availability and quality of the data to be used for stress testing purposes.

Regulatory Stress Tests and Bank Responses

In this paper, we investigate how the regulatory stress test framework in the European Union affects banks’ investment decisions and portfolio choices. Using the causal inference and event study methodology, we document a substantial impact of EU-wide stress tests in 2011, 2014 and 2016 on the banks’ portfolio strategies. The banks subject to regulatory stress tests tend to structure their portfolios with lower risk assets that is reflected in a decline in risk-weighted assets as compared to the control group. At the same time, the dynamic of realized risk that is measured by the proportion of non-performing exposure in portfolios remains unaffected. The estimates based on two alternative subsamples indicate that the magnitude of such effect rise with the increase in the size of the bank´s assets.

Mapping swap rate projections on bond yields considering cointegration: an example for the use of neural networks in stress testing exercises

This paper discusses the application of techniques of business analytics in the banking industry examining stress tests in the context of financial risk management. We focus on the use of neural networks in combination with techniques of cointegration analysis to map swap rate projections derived from given scenarios (e.g., a certain stress scenario from the EBA/ECB 2016 EU-wide stress test) on other relevant interest rates in order to ensure that contingent projections for these time series are produced and used in the process of stress testing.

Are stress tests beauty contests? (and what we can do about it)

There is increasing debate on whether official-sector stress tests are fit for purpose and deliver what they are designed for. In the European Union, this discussion focuses not only on the costs and benefits of such a large-scale bottom-up exercise and on the possible options to improve its usefulness for banks, supervisors and the general public, but also on exploring ways to make it less burdensome. This paper discusses whether some improvements to the design of the EU-wide stress test could better align the incentives of the different stakeholders involved. In particular, the objective is to understand whether there is room for mitigating the beauty contest problem, namely the problem that banks are more interested in showing that they are outperforming others than in identifying actual risks in an adverse scenario.

Information Value in EU-Wide Bank Stress Test

The paper starts with an evaluation of the banks’ solvency information disclosed in the 2018 and 2016 EU-wide stress tests, asking do they add value to the information available in the bank capital ratios observed at the start of the stress exercise? It argues that information from price-to-book, degree of imperfect information on the value of assets and relative holding of domestic government bonds all require a bank-specific approach in the supervisory review and evaluation process (SREP) exercise. In short, one size does not fit all.

Are Stress Tests Beauty Contests?

There is increasing debate on whether official-sector stress tests are fit for purpose and deliver what they are designed for. In the EU, this discussion focuses on the costs and benefits of such a large-scale bottom-up exercise and on the possible options to improve its usefulness for banks, supervisors and the general public, but also on exploring ways to make it less burdensome. This paper discusses whether some improvements to the design of the EU-wide stress test could better align the incentives of the different stakeholders involved. In particular, the objective is to understand whether there is room for mitigating the beauty contest problem, namely the problem that banks are more interested in showing that they are outperforming others than in identifying actual risks in an adverse scenario.

Macro stress testing euro area banks’ fees and commissions

This paper uses panel econometric techniques to estimate a macro-financial model for fee and commission income over total assets for a broad sample of euro area banks. Using the estimated parameters, it conducts a scenario analysis projecting the fee and commission income ratio over a three-year horizon conditional on the baseline and adverse macroeconomic scenarios used in the 2016 EU-wide stress test. The results indicate that the fee and commission income ratio is varying in particular with changes in its own lag, the short-term interest rate, stock market returns and real GDP growth. They also show that the fee and commission income ratio projections are more conservative under the adverse scenario than under the baseline scenario. These findings suggest that stress tests assuming scenario-independent fee and commission income projections are likely to be flawed.

The Financial Stability Aspects of the EU-wide Stress Test

The Financial Stability Aspects of the EU-wide Stress Test

Correlation between the 2014 EU-wide stress tests and the market-based measures of systemic risk

In this paper, we compare the results of the European Banking Authority (EBA) stress tests conducted in 2014 with the market-based measures of capital losses, which are the marginal expected shortfall (MES), the systemic risk measure (SRISK) and the delta conditional value at risk (ΔCoVaR). These measures allow us to estimate the expected capital shortfall in the case of a crisis. The empirical analysis is performed on a sub-sample of the banks included in the stress test exercise, because only 57 European banks, in 22 countries, are publicly traded. We find that the SRISK is the best predictor of systemic risk among the 3 systemic risk measures, since it is the most correlated with the stress test results. Furthermore, we focus on the realized outcomes (realized loss, realized return and realized volatility) and compare them with the 2014 EU stress test results.

A review of stress test methodology

After a general introduction of the concept of bank stress testing, and the possible applications by different stakeholders, the paper provides an overview of the European Banking Authority (EBA) EU-wide stress test. It explains its main features, the scope of risks assessed, the different actors involved and the benefits of the exercise. It also explains the role of the EBA in the different stages of the exercise, the evolution of the exercise and its purpose as a tool to assess potential vulnerabilities of banks and their resilience to adverse market developments, provide transparency on banks’ exposures and as a supervisory tool. The paper then focuses on the 2018 EBA stress test and explains the main changes applied to the EBA stress test methodology in 2018 for the different risks. The paper pays special attention to the changes linked to the implementation of the new International Financial Reporting Standard (IFRS 9). It elaborates on the effects of IFRS 9 and the implications of the IFRS 9 rules for the credit risk stress test in terms of lifetime expected credit losses, the definition of stages and the movement of exposures between stages.

Stress test impact and bank risk profile: Evidence from macro stress testing in Europe

This study investigates the risk profile of banks that get a significant capital level reduction in the EU-wide stress test exercises. Using the CAMELS multifaceted risk approach, we look into the connection between the bank risk factors and the macro stress testing impact on capital. The results show that financial institutions that are inefficient or complex, with low profitability levels and small loan portfolio, receive highly negative results in the stress tests. As this risk profile is not consistent over time, the results support the stress tests disciplinary role, suggesting risk management strategy adjustment through consideration of prior stress test outcomes.

Asset commonality of European banks

In this paper, we investigate the notion of asset commonality. We describe the evolution of asset commonality, for 43 European banks over 15 countries, by comparing the 2011 and 2016 EU-wide stress test reporting. We determine the main variables that influence asset commonality and its evolution. We notice that asset commonality can be used as a complementary measure to other market systemic risk measures. Furthermore, we find that asset commonality can influence the returns negatively and the volatility of the bank positively. We also find that some banks, which have no funding problems or fire sales, have experienced a decrease in their performance. Asset commonality can be seen as an interesting tool than can be used by regulators.