Gerd-Jan van Wiggen: How do you break a bank?
By Gerd-Jan van Wiggen, Partner at Probability & Partners
After the holiday period, it is always nice to come home knowing that a number of interesting publications have been released. One of these is the ECB paper setting out the results of the reverse stress test, which was published on 31 July.
The concept of a reverse stress test is a good one, and although banks carry them out regularly, they do not feature very often in stress tests mandated by the regulator. The standard EBA stress tests present a dire scenario which banks run through, from which the impact on capital ratios is then derived. In a reverse stress test, banks are asked to consider which scenarios could result in their capital ratios being significantly affected.
In the case of the ECB stress test, banks were asked to identify scenarios that could result in an impact of 300 basis points on the CET1 ratio. To put this into context: the ECB states that the median CET1 impact of a crisis over the past 15–20 years for European banks was between 225 and 250 basis points. It therefore appears that a slightly more conservative baseline has been chosen than historical data suggests. These figures are not entirely comparable with the results of the EBA stress test, as different assumptions were used. It is also worth noting that the calculations relating to capital ratios have changed significantly over the past 15–20 years. Twenty years ago, we were still just under the Basel I regime; we are now operating under Basel IV.
With this as a starting point, banks have examined the major risks that are currently apparent. Geopolitical risk ranks highly as a source of doomsday scenarios that could bring about a bank’s own downfall. The closure of the Strait of Hormuz, further escalation of the war in Ukraine, Sino-American trade disruptions, and tensions surrounding the Taiwan Strait are recurring themes for many parties, and their impact is translated onto the bank’s balance sheet via various transmission channels.
Non-financial risks also had to be taken into account. Within this category, cyber-attacks were the most significant, in line with the scenarios mentioned above. Disruptions to third-party and customer services, as well as to products and business practices, were also common.
One area of concern relates to liquidity and funding stress. Although the results appear favourable, the ECB’s analysis shows that not every bank translated the stress events into a significant impact on liquidity ratios, whilst the impact on capital ratios was substantial. The same applied to a greater extent to liquidity metrics in other currencies. The ECB therefore recommends giving due consideration to the relationship between capital and liquidity.
After analysing the impact, the banks also examined mitigating measures. These included cost reductions and changes to dividend payouts. In general, such measures are considered plausible. In some cases, the sale of portfolios was also considered, although it was noted that this would not be feasible in a situation of widespread market stress.
The results of the reverse stress tests will be taken into account in the supervisory dialogue with the banks and may potentially lead to additional requirements under Pillar 2.
How can you, as an investor, use this information? It is useful to see that, on average, the banking sector is in a more robust position than it was 10–15 years ago and can withstand a geopolitical shock. However, this reverse stress test focuses on sector averages, and it is difficult to identify the weaker players. The banks’ disclosures in the coming period will provide more detailed information on this. How is an increase in the Pillar 2 requirement explained? Are there any hidden issues that you can read between the lines? What will happen with rising government debt, rising interest rates and the impact on banks’ liquidity buffers? I think it would be wise to study the disclosures carefully in the coming period.
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