Banking sector stress tests in the EU*

1. Reiner Martin Deputy Head of Division Macro-Financial Linkages European Central Bank Banking sector stress tests in the EU* *The views presented in this paper are exclusively those of the authors and not necessarily those of the ECB. Mendel University Brno 16 October 2015

2. Outline • Introduction and terminology • Banking sector stress tests at the ECB/SSM • The ECB top-down stress testing framework • The Comprehensive Assessment 2014 • Outlook

3. Introduction and terminology ECB-RESTRICTED DRAFT • Banking sector stress tests gained significantly in importance since the start of the financial crisis in 2007/08 • On-going debates / discussions with(in) ECB/SSM, EBA, NCAs/NCBs, IMF…as well as in the financial sector itself! • Terminology • (Constrained) Bottom-up vs. Top-down • Solvency vs. Liquidity • Contagion / Networks

4. Banking sector stress tests at the ECB / SSM ECB-RESTRICTED DRAFT • Top-down – for macroprudential purposes • Quarterly risk impact assessment for the ESRB (EU-wide) • Bi-annual corresponding exercise for the Financial Stability Review (public) • Regular macroprudential impact assessment for the Eurosystem • Top-down for system-wide exercises • (Crisis) country-specific and SSM-wide • Bottom-up – for microprudential purposes • SSM-wide (banks' results for publication) • Input into regular bank-specific supervision (SREP)

5. The ECB’s top-down stress testing framework The ECB top-down stress testing The ECB’s top-down stress testing framework Key features of the model: • Uses granular data of around 130 large SSM banks • Is contingent on a macroeconomic scenario • Accounts for direct impact on banks’ balance sheets • Is complemented with modules to take into account : • Dynamic reaction of banks to macro-prudential policies • Contagion across banks • Macroeconomic models accounting for second round effects on the real economy

6. The ECB’s top-down stress testing framework The ECB top-down stress testing framework Top-down banking sector stress testing framework A. ECB Stress Testing Framework: Overview Forward-looking solvency analysis Satellite models Balance sheet Scenario Feedback Loan loss models Funding shock Credit risk models RWA Contagion models Financial shocks Market risk and securitisation models Balance sheet and P&L tool => Solvency Macro models Profit models Macro feedback models Dynamic adjustment model Sources: Henry and Kok (eds.), ECB Occasional Paper 152, October 2013.

7. Cross-country macro scenario design has to balance various factors: Adherence to macro-financial story line Model-based versus expert-based approach to shock-calibration Model consistency vs. ad hoc assumptions Need to ensure substantial stress being imposed on all banks in the exercise? A mixture of model-based and judgemental assumptions Cross-check: use top-down stress test framework during bottom-up scenario design process to gauge severity A. ECB Stress Testing Framework: Overview The ECB’s top-down stress testing framework The ECB top-down stress testing framework

8. The ECB’s top-down stress testing framework The ECB top-down stress testing framework Elements of the scenario design • EU macro: “Stress Test Elasticities” (STE) • Multi-country EU-wide shock simulation tool based on impulse response functions (from EU central banks’ models) of endogenous variables to pre-defined exogenous shocks • Allow for country-specific shocks and incorporate EU-wide spillovers (via a trade link block) • CRE pricesoutside the system and modelled by satelliteequations • Non-EU macro: external models (e.g. NIGEM) • A separate toolbox is used to derive pure financial shock scenarios: non-parametric copula approach to simulate joint/multivariate forward distribution of financial variables (model free, can handle large # variables)

9. The ECB’s top-down stress testing framework The ECB top-down stress testing framework Satellite models • Credit risk: • Estimation of country aggregate, product-specific model equations • LGD model based on stressedcollateralvalues and LTV ratios (a function of house prices) • Net interest income: • Estimation of country aggregate, product-specific model equations • Models for retail interest rates and for wholesale funding costs • Other pre-provision income: • Based on assumptions rooted in EBA methodology • Fee & commission income model (bank panel regression framework) • Market risk and securitisation: • Asset shock calibration (distinguishing between Held for Trading and Available for Sale / portfolios) • Projections of Credit Valuation Adjustments (CVA) • Projection of securitisation book using rating migration matrices

10. The ECB’s top-down stress testing framework The ECB top-down stress testing framework Overview of solvency calculation Definition of capital (country specific) Input from profit and loss module Net operating income Existing capital + ≤ Solvency ratio (minimum threshold) Risk weighted assets potential capital shortfall Input from RWA module

11. The ECB’s top-down stress testing framework The ECB top-down stress testing framework Interbank network and contagion models are used to: Select relevant interbank networks of direct exposures • Static network: can be based on observed networks (e.g. EBA collection, Target 2) or simulatednetworks (Hałaj & Kok (2013,2015)) • Dynamic network: changes in the network take changes in market parameters impacting banks’ counterparty credit risk into account Simulate default cascades, initiated by banks with shortfalls projected by the BST • Knock-on (domino) effects: default causes other defaults (based on LGD assumptions); • Clearing payment: equilibrium payment after all flows of payments stabilise (endogenous LGD)

12. The ECB’s top-down stress testing framework The ECB top-down stress testing framework Macro feedback models Used to calculate the impact of the changes in bank balance sheets on macroeconomic variables (GDP, investment, consumption, housing, etc.) Vector autoregressive models (GVAR/VAR): estimate endogenous relationships between real and financial variables including proxies for regulatory/macro-prudential measures, such as capital and liquidity ratios. (Gray, Gross, Paredes and Sydow (2013), Gross (2013), Gross and Kok (2013) ) Dynamic general equilibrium models: derive macroeconomic and financial relationships from microeconomic principles modelling directly the pass-through mechanism of shocks to macroeconomic and financial variables. (Żochowski(2014), Darracq Pariès, Kok and Rodriguez Palenzuela (2011))

13. The Comprehensive Assessment 2014 3.2 Looking back to the CA ST bit – combination of the 2 ECB-RESTRICTED DRAFT Key features of the Comprehensive Assessment 2014 • One-off exercise: starting point for and pre-condition to SSM • Next time will be different – now the SSM is there! • Timeline, methodology, templates, publication (largely) in common with EBA • 2 Components - an Asset Quality Review and a constrained bottom-up stress test with top-down quality control

14. 4.2. CET1 projected to decrease by 4% under the adverse scenario The Comprehensive Assessment 2014 Reduction in bank capital ratios under the adverse scenario SSM median: 4.0%

15. 4.4. Under the adverse, SSM average CET1 declines from 11.8 to 8.8% The Comprehensive Assessment 2014 Breakdown of aggregate impact of ST under the adverse scenario • Weighted means; excluding the AQR impact on starting point capital • NB: LLP and NII key drivers to the deviations from baseline CET1.

16. 4.3. At least one bank with a capital shortfall in 11 of the 19 countries The Comprehensive Assessment 2014 Capital shortfall by country Total shortfall (€ BN)

17. 5.2. Comparing Bottom-Up and Top-Down results The Comprehensive Assessment 2014 ECB-RESTRICTED DRAFT Top-down vs. Bottom-Up results • Top Down results were generally somewhat more “conservative” • So called ‘Quality Assurance Process’ led to gradual convergence of results over time • Supervisory dialogues meetings bridged the remaining gap at the end of the process • Top-down results helped the QA process and ultimately helped to boost credibility of the SSM banking sector

18. The Comprehensive Assessment 2014 5.3. Around the CA – The exercise brought banks closer to other firms Bank equity prices came closer to those of other firms Source: Bloomberg

19. 5.5. Around the CA – Decoupling banks from sovereigns The Comprehensive Assessment 2014 Decoupling banks from sovereigns Source: Datastream

20. Outlook ECB-RESTRICTED DRAFT • The ECB/EBA banking sector stress test 2016 will again be a constrained bottom-up exercise with top-down-driven QA (but no AQR!) • Other countries follow different approaches, e.g. the US • Stress test ‘construction sites’: • Solvency stress tests • Stress tests for non-bank financial firms (insurers, pension funds, ‘shadow banks’) • Network analysis (within sectors and beyond)

21. Annex slides

22. The ECB’s top-down stress testing framework The ECB top-down stress testing framework Overview of P&L calculation Profit and loss calculation Net interest income Loan loss calculation Balance sheet Market risk Net interest income + Net fee and commission + Net trading income – Staff expenses – Depreciation and amortization – Administrative expenses – Other net operating income = OPERATING PROFIT/LOSS – Provisions on loans and advances – Other provisions (e.g. financial assets, goodwill) = PROFIT/LOSS BEFORE TAXES – Taxes – Minority interest = NET INCOME/LOSS Evolution of main balance sheet items Interest Income and expenses calculation Loan loss and impairment calculation Trading income Foregone interest income on NPL Balance sheet assump- tions Input from interest rate models Input from loan loss models Input from various models Input for other income/expense components