It has been almost six years since the EBA published the results of its first EU-wide stress test exercise. Since 2011, the EBA has conducted three stress test exercises, in 2011, 2014 and 2016, and a recapitalisation exercise in 2011/2012. EBA is now in the preparatory phase for the next EU wide stress test, which will run in 2018. Although the EBA exercises have not been exempt from some criticism, they have led to a significant strengthening of the capital position of European banks. Detailed disclosure of the results has also reinforced market discipline and contributed to restore confidence in the financial sector after the crisis.
It is also important to underline the merit of disclosure, which proved to be a valuable instrument during the sovereign crisis. Perfect knowledge and transparency are preconditions for competitive markets, helping investors to price risk and assess assets. On the contrary, lack of information, poor comparability of the scarce data available, and concerns on the reliability of the information disclosed – as it was the case at the peak of the crisis – can lead market participants to think the worst of each and every bank. In turn, such perception of a high level of risk of banks is conducive to freezes in funding markets, which may also damage banks which are in relatively good conditions, thus hampering the ability of the whole banking sector to fulfil its basic functions.
The publication of EBA‘s stress test results has been traditionally very detailed, with a large amount of bank-by-bank actual data and projections. This underpins the EBA’s ongoing efforts to foster disclosure and market discipline in the EU internal market; provides transparency on banks’ exposures; helps to address uncertainties that may affect the EU banking sector as a whole, contributing to a higher confidence by stakeholders; and facilitates comparability across banks.
The EBA exercise is based on a general macroeconomic downturn scenario over a 3-year horizon. While the scenario is linked to a specific trigger, the stress impact is driven by the severity of the overall shock over three years. Any given significant shocks will likely cause a recession which would translate into bank losses. It is crucial to communicate this properly, so that market participants understand that even if specific risks that may arise and materialise during the course of the exercise are not included in the scenario, it remains relevant for the purpose of the exercise. We have a long experience of events that cast doubt on our macroeconomic scenarios, from the sovereign debt crisis in 2011 to the UK referendum in 2016. This, however, doesn't detract from the usefulness of the stress test as a supervisory tool, provided that its limitations are clearly understood and communicated. Rather, it emphasises that stress testing should be viewed as one important tool amongst a number of supervisory tools. Last year, we put very much emphasis, for instance, in explaining the move away from a pass-fail exercise typical of a crisis situation to a supervisory stress test, more suitable for ordinary times.
Andrea Enria in his speech said: “the conclusion here is that, fallible as they may be, the conduct of annual stress tests gives the regulatory authorities their best available chance of dealing with fragile banks while there is still enough time to avert a, potentially contagious, failure”.
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