The ECB’s stress tests: what got stressed and what do the results mean?

You’ve seen the headlines by now: the European Central Bank’s stress tests showed 25 banks out of 130 with insufficient capital, and 12 of those have already raised further assets. The rest of Europe’s tested banks (82% of total bank assets) have gotten a clean bill of health. This sounds great on paper but caused us some concern. We wanted to know for example what passing or failing the test actually means. The answer is important for understanding how strong Europe’s banking system is today and how far it needs to go in the future for a full recovery.

First of all, here’s a synopsis of the ECB methodology, from the full results of the stress test published on October 24 2014:

1) A sample of portfolio quality, including loans that had not been serviced in more than 90 days:

The portfolios were selected for detailed analysis following a risk-based approach, the aim being to cover those portfolios with the highest chance of material misstatements compared to available capital.

2) A pretty good review of the credit file and collateral valuation (no netting)

3) 15 special cases were evaluated including institutions with no or minimal credit risk and institutions with a high degree of intra-company transactions.

4) A test on Common Equity Tier 1 (CET1) vs. CET1 in stressed conditions:

The stress test exercise was performed under a static balance sheet assumption with the objective of achieving simplicity as well as cross-bank consistency and comparability. This implies a zero growth rate assumption for the balance sheet and the constant maturity profile of the bank’s assets and liabilities over the horizon of the stress test confirmed by replacing maturing instruments with similar financial instruments in terms of type, credit quality and maturity.

Both the banking book and the trading book (including off-balance sheet items), as well as income and expenses, were subject to stress.

The adverse scenario was designed to reflect the systemic risks that were assessed as representing the most pertinent threats to the stability of the EU banking sector.

On average in the euro area, the adverse scenario leads to deviation of euro area GDP from its baseline level by -1.9% in 2014, -5.1% in 2015, and -6.6% in 2016. The euro area unemployment is higher than its baseline level, by 0.3 percentage points in 2014, by 1.2 percentage points in 2015, and by 2.2 percentage points in 2016.

The headlines in the papers are the direct result of the ECB’s testing methodology. A tougher set of criteria on portfolio quality would mean a greater capital shortfall, and vice-versa. Both Bloomberg and Reuters articles cited some doubts on the outcome of the stress tests:

Bloomberg: The simulated scenario was too lenient because it didn’t incorporate deflation in southern Europe, said Hans-Werner Sinn, president of Munich-based Ifo Institute. That explains why the capital shortfall was so small for many banks, he said in a statement.

Reuters “This seems as if it has been pretty unstressful,” said Karl Whelan, an economist with University College Dublin. “The real issue is the size of the capital shortfall and that is very, very small. I don’t feel a whole lot more reassured about the health of the banking system today than last week.”

The Wall Street Journal noted some technical errors but “The issues appear to be isolated and, unlike in previous iterations of the European stress tests, don’t call into question the overall credibility of the exercise, according to analysts and other experts. They said some mistakes are inevitable when compiling over a million pieces of data.”

Our impression is that given the selection of portfolio samples that cannot be extrapolated to full bank holdings, this stress test is okay. It would be better to have a fuller portfolio analysis but we’ll take the headlines for the time being, albeit with a small grain of salt.

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