Thursday, 4 August 2016

Fitch: Key Assumptions Shape European Bank Stress Test Results

In World Economy News 04/08/2016

Results of the bank stress test published by the European Banking Authority (EBA) on 29 July uncovered no real surprises but highlighted that a handful of assumptions are key to determining how banks’ capital holds up under the stress scenarios, says Fitch Ratings.
A preliminary analysis of the EBA data shows that, in addition to stress assumptions around credit risk, a bank’s conduct track record, the extent to which it is involved in trading activities and the hedging strategy it applies to interest-rate risk in its banking book are factors which resulted in capital adequacy erosion under the stress assumptions applied. Credit risk stresses are influenced heavily by macroeconomic assumptions about a bank’s home country, the composition of its loan book, and the extent of already defaulted loans.
A common baseline, stressed macroeconomic scenarios and risk-specific shocks covering the period 2016-2018 were applied to the 51 banks included in the EBA stress sample. The macroeconomic adverse scenarios and risk-specific shocks linked to the scenario were developed by the European Systemic Risk Board and the ECB, in close collaboration with national regulators. The European Commission provided the baseline scenario. The macroeconomic data points are important because banks translated them into corresponding default and loss probabilities which affect both their capital levels through income statement losses and other comprehensive income, and their risk-weighted assets.
However, the projections of GDP growth, unemployment rates and prices for residential and prime commercial real estate vary considerably across the 15 domestic markets of banks included in the sample.
Stresses applied to some countries are much harsher than others. The Netherlands and Sweden are the only countries where GDP drops each year during the adverse scenario timeline. Residential real-estate prices fall sharply in Sweden, Denmark, Spain, the UK, Austria and Poland, while scenarios are far milder for France, Germany, Italy and Finland. Only moderate unemployment assumptions are used for Germany, France, Italy and Austria, and these contrast with more severe projections for the UK, Sweden, Denmark, Poland and Ireland. In our opinion, these differences go some way to explaining why cumulative credit losses are more significant drivers of change in banks’ stressed capital ratios in some countries than others.
An assessment of future conduct risks is a new feature in this year’s stress test but disclosure is not sufficiently transparent to single out conduct risk components by bank. They are grouped together with other operational risks. Although the EBA’s guidance provided some fairly conservative parameters for calculating conduct risk charges, we understand from discussions with banks that assumptions and adjustments may have varied considerably among banks.
Importantly, swings in interest revenue and expense projections vary considerably across banks used in the sample, especially on a gross basis, and in some cases this has translated into net interest income (NII) variations that had a major impact on the outcome of some of their stressed capital ratios. The EBA assumes a rise in rates over the period covered by the test, varying by currency, and requires the deduction of lost interest income on defaulted assets. It also prescribed specific rising funding costs under the adverse stress equating to a two-notch rating downgrade, with lower rated banks more severely affected regardless of funding profiles. This explains why banks with poor existing asset quality and lower current ratings experienced higher levels of NII erosion under the test.
We also noted some more complex variation on stressed NII projections among banks relating to the hedging of trading-book and banking-book exposures. We think the NII projections may be highly sensitive both to the hedging strategies adopted by individual banks and to how they account for the hedges in specific income statement lines. Hedges that match actual market exposure in the banks’ balance sheets may have been prevented from matching stressed projections because constraints on upside margin calculations in the EBA’s guidelines will have skewed the net result. This is a technical topic which we intend to explore more fully with individual banks.
Source: Fitch Ratings