For any stress test, the essential question is one of the hurdle rate – the capital position an institution has to hold after stress effect to be considered as sound.
The EBA’s stress test 2016 has reached its peak. Institutions submitted to the EBA the results and explanatory note for the first part of the test in April. Now, it’s time for the supervisors to run their process of challenging the banks’ submissions.
In such an exercise, the essential question is one of the hurdle rate – the capital position an institution has to hold after stress effect to be considered as sound. In the 2014 exercise this was 8 percent CET1 for the baseline and 5.5 percent CET1 for the adverse scenario. Unlike the 2014 stress test, the 2016 test has no official or publicly communicated hurdle rate to pass. This sounds like good news at first glance, but includes some uncertainty, however.
One approach to determine what the hurdle rate may be is to consider the minimum requirements. For example:
In this case, the minimum CET1-ratio for the bank in the example above would be 11.5 percent (i.e. 10+1+0.5) accordingly.
So, what is the hurdle rate to pass the stress test in this example? In the baseline scenario, it should be simply the above mentioned minimum requirement of 11.5 percent CET1. Things get a bit trickier in the adverse scenario, however. This is even more important as experience from 2014 shows that most banks struggled more to pass the mark in the adverse scenario. Three scenarios of uncertainty, can be considered as shown below:
In summary, the hurdle rate(s) for the bank described above can be considered to be:
Depending on the individual “performance” of the bank in the stress test and the performance in the overall SREP 2016 process, the individual hurdle rate is skewed more to the left or right of that interval. Given the sheer amount of capital requirements, a proper performance in both exercises – SREP as well as stress test – is key to ensure a proper return on capital. Experience shows that both exercises are not easy: insufficient data quality and automatization, manual processes, ad-hoc developed tools and solutions, tight deadlines and uncertainty of requirements pose challenges.
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