27 February 2017

ECB: Macro stress testing euro area banks' fees and commissions

This paper estimates a macro-financial model for fee and commission income over total assets. 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.

The recent financial and sovereign debt crises highlighted the importance for economic activity of having sound banks able to withstand extreme and unexpected shocks to their balance sheets and able to generate sufficient income even in times of distress. Indeed, banks resilient to stress and able to act as effective financial intermediaries over the economic cycle are a necessary condition for ensuring a smooth ow of credit to the real economy also in periods of economic turbulence. With the aim of ensuring a well-functioning financial system to support economic growth, macro stress-testing frameworks are often used to assess in a forward-looking manner the resilience of the banking sector to (adverse) macroeconomic and financial developments.

The main purpose of macro stress testing is to assess the sensitivity to adverse macroeconomic and financial developments of individual banks' balance sheet and profits and losses.  While most stress testing tools typically have well-developed modules for projecting loan losses and net interest income, other sources of income and expenses are often only modelled in a rudimentary fashion. This ignores that other parts of banks' net income may be also related to macroeconomic and financial developments. In other words, these stress testing approaches may risk overlooking key elements of banks' income generating activities, such as income from fees and commissions which together with net interest income and net trading income are the three most important income sources for most banks. In fact, fees and commissions constitute on average between 22% and 30% of euro area banks' net revenue and about two thirds of euro area banks' total non-interest income. Therefore, stress tests that ignore the sensitivity to macroeconomic conditions of such an important income source may potentially underestimate the volatility of banks' solvency position when exposed to stress events.

Against this background, this paper proposes a model for estimating the relationship between some key macroeconomic and financial factors and fee and commission income over assets, using yearly data between 1995 and 2015 for a large sample of euro area banks. Then, it shows how the estimated model can be applied to stress test the resilience of this source of revenue conditional on the baseline and adverse macroeconomic scenarios used in the 2016 EU-wide stress test.

More specifically, the empirical strategy adopted in this paper begins with the selection, out of a predetermined group of macroeconomic and financial factors, of the independent variables that have the most explanatory power for fee and commission over assets, our variable of interest.

This selection approach yields as the most relevant drivers the lag of fee and commission income over total assets, the lag of the first difference of the short term interest rate, the stock market returns (both the lagged and the contemporaneous variable), the lag of the first difference of the long term interest rate, residential property price growth and the real GDP growth. In a second step, a model for fees and commissions over assets including the selected regressors is estimated.

The results show that lagged fee and commission income over assets, the contemporaneous stock market returns and real GDP growth are positively and significantly related to fees and commissions over assets, while the first difference of the short term interest rate is negatively and significantly associated to our variable of interest. Finally, this study provides a scenario analysis which highlights the usefulness of the estimated model in a stress-testing context. Indeed, the estimated parameters are used to project fee and commission income over assets over a three year horizon conditional on both a baseline and an adverse macroeconomic scenario. This scenario analysis illustrates how fees and commissions over assets, aggregated at country level for 18 euro area countries, are sensitive to the different macroeconomic developments. Indeed, the resulting fees and commissions projections are considerably more conservative under the adverse scenario than under the baseline scenario.

Full working paper

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