The Future of Stress Testing The Future of Stress Testing The Future of Stress Testing

This year’s stress tests have barely begun, but the ECB already has one eye on the future. A new framework is in the pipeline. The details remain unclear, but banks should expect significant changes from 2022 onwards.

Stress tests are an essential tool for banking supervisors. European banks may currently be focused on 2020’s round of tests, but the ECB and EBA are already turning their thoughts to the future.

Recent speeches by ECB Supervisory Chair Andrea Enria¹ and ECB Vice-President Luis de Guindos² show that the supervisor is well aware of the current approach’s limitations. On the upside, using the same stress test rules for every bank enables supervisors to benchmark all participants on a level playing field. However, this does not represent a very realistic test, and can encourage ‘window dressing’. The methodology, governance, politics and communication of the current framework have also grown increasingly complex over time.

The net effect of these factors is that the stress tests are increasingly seen as a compliance exercise, and that their outputs are viewed as less and less meaningful. For example, most banks no longer think the test results will help drive their business decision and planning (excluding the effects on P2G).

So the necessity to redesign the stress tests is hardly surprising. In fact, we expect the current tests to be the last ones under the existing methodology. Little is known about the new framework, but we expect it to be comprised of three pillars:

• Supervisory view. This should represent a more efficient, less data intensive version of the current bottom-up approach. Using constrained projections based on banks’ internal balance sheet models, it will aim to gauge the Pillar II Guidance impact of different exposure ‘buckets’.
• Bank view. This will be run in parallel with the Supervisory View (which will be used as a benchmark), but with the option to relax constraints such as the static balance sheet assumption. That should allow individual banks to make ICAAP-like adjustments based on their risk profiles and vulnerabilities.
• Macro view. Instead of another ‘side by side’ test, this is expected to constitute a top-down sensitivity analysis of an additional set of macro elements. One possibility might be to test banks’ sensitivities to certain climate-related threats – something that the EBA has suggested it wishes to introduce.

With the details of the new framework yet to be confirmed, it is too early to identify its full implications. But it seems likely that a three-pillared stress test will require a significant effort from banks to identify, extract and collate data from their various business units, entities and functions. It’s also possible that the EBA could begin trialling climate change sensitivity analysis as soon as 2020 as part of its regular risk assessment activities³. We see some other key questions about the new approach as including:

• Whether continuing to use the same scenarios for all banks will limit the value of the Supervisory View. It may make more sense to cluster banks into groups, tailoring scenarios to each cluster – although there is no sign yet of supervisors adopting this approach.
• How closely aligned the scenarios for the Supervisory View and Bank View will need to be, how close the Bank View may be to the ICAAP stress test, and how much duplication of effort this may create.
• How any major discrepancies between the Supervisory View and the Bank View will be addressed. For example, publication of the Supervisory View might place banks under implicit pressure to align the outcomes of their Bank View with the ECB’s conclusions.
• How effective any climate risk sensitivity analysis will be, given the scarcity of detailed, credible data and the huge difficulties of resolving this issue.

Of course, these questions may be addressed as work on the new framework advances. We expect banks to be consulted on the new methodology, and the EBA’s Action Plan on Sustainable Finance also calls for engagement with a sample of banks over the challenges posed by climate risk analysis.

For now, preliminary discussions with clients lead us to believe that – while some banks are more concerned than others – the industry is cautiously positive about the incoming framework. It’s now up to supervisors and banks to engage closely with each other and maximise the value of the new stress tests. The next two years will go quickly!

Latest update – On 22 January, the EBA published a consultation paper on the future of stress test which provided more detailed insights on the potential features of the tests starting from 2022. KPMG ECB Office will shortly cover this in a later article.