(Extract from page 4 of BIS Quarterly Review, September 2010)
The EU bank stress tests were designed to assess the resilience of the EU banking system to a range of adverse economic and financial market shocks. They were conducted by the Committee of European Banking Supervisors (CEBS), together with the ECB, European Commission and national supervisors. The tests covered 91 banks from 20 EU member states representing about 65% of EU banking assets and at least 50% of assets in each respective member state. Spain had the greatest coverage, with 27 banks participating, covering almost 100% of banking assets. Results at both an EU aggregate and individual banking group level were released on Friday 23 July after the close of European trading. The same day, the Swiss bank regulator FINMA also announced that the two largest Swiss banks had passed their stress tests.
The EU bank stress tests examined three macroeconomic scenarios over the two years ending December 2011: (i) a benchmark scenario reflecting the EU economic outlook of 1.0% GDP growth in 2010 and 1.7% in 2011; (ii) an adverse scenario where aggregate GDP dips 3% below the EU forecast over the two-year period; and (iii) the adverse scenario combined with a sovereign shock. The sovereign shock was modelled as an upward shift in the government yield curve in all EU countries, with additional country-specific increases in long-term government bond yields. The authorities provided a common set of macroeconomic variables across each scenario for each EU member state, the United States and the rest of the world. To pass the test, banks needed to maintain a Tier 1 capital ratio greater than 6% under each of the scenarios (vs the regulatory minimum of 4%).
Most of the banks easily passed the stress tests, with the EU aggregate Tier 1 ratio under the toughest scenario falling from 10.3% at end-2009 to 9.2% by the end of 2011. Under this scenario, aggregate loan impairment losses were €473 billion over the two years, trading losses were €26 billion, and the sovereign shock added €67 billion of losses. Banks' expected operating income over the two-year forecast almost exactly offset these losses.
Seven banks did not maintain a 6% Tier 1 capital ratio, and need to raise a combined €3.5 billion of capital. Another 20 banks had capital ratios between 6% and 7%. The banks with a capital shortfall were five Spanish savings banks ("cajas") (needing €1.8 billion), Hypo Real Estate of Germany (€1.2 billion) and Agricultural Bank of Greece (€0.2 billion). Authorities are working with these banks to raise their capital ratios or restructure them. Backstop facilities had already been put in place in some countries ahead of the release of the stress test results, while authorities in others have announced that government funds are available if needed.
Critics of the exercise argued the stress tests were not demanding enough. The tests did not consider the impact of a euro sovereign default, so they did not stress the prices of government bonds held in banking books (the vast bulk of banks' holdings). The tests also focused on existing Tier 1 capital ratios, rather than the more demanding core Tier 1 ratios, although the difference between measures is only important is some countries. Despite these criticisms, the market welcomed the greater transparency provided by the tests, particularly the consistent data on individual banks' holdings of EU sovereign bonds.
Over the weeks prior to the release of the EU stress test results, bank stocks outperformed the broader market indices and bank CDS spreads narrowed, possibly in anticipation of a positive outcome. The immediate market reaction after the release of the official results was positive, with European banks' share prices rising by 2% and their CDS spreads decreasing by 10 to 15 basis points on the first trading day after their release. Over the subsequent weeks, the rise in bank stocks and narrowing of CDS spreads continued, although the stress test effect cannot be distinguished from the response to the Basel Committee's updated capital and liquidity reform package. Also, a number of banks released positive earnings over this period. Access to market funding reportedly improved for the largest banks following the release. Consistent with this, bond issuance from European banks has increased, most notably for the biggest Spanish banks. But anecdotal reports suggest that medium-sized and smaller banks are still facing difficult financing conditions.