Stress Testing Financial Stability

Department of Economics

Faculty of Economics and Behavioral Sciences

University of Freiburg

Seminar paper in

Financial Stability

Prof. Dr. Martin Goetz

(Goethe University Frankfurt/Main)

Stress Testing: History of Stress-testing

in Europe and the U.S.

Ivan Dyachok

IMP, Finance, 8th Semester

Mart. Number: 3352663

Merzhauser Str 160

79100 Freiburg

Ivan Dyachok, 3352663

2

Contents

List of Tables ........................................................................................................................ 3

List of Figures ....................................................................................................................... 3

Table of Abbreviations .......................................................................................................... 5

Stress Testing in Europe and the US: Overview ................................................................... 7

Design of Stress Testing in the United States .................................................................. 8

Design of Stress Testing in the European Union ............................................................ 10

Outcomes and Implications of the Latest Stress Testing .................................................... 11

Criticism .............................................................................................................................. 18

Conclusions ........................................................................................................................ 20

Works Cited ........................................................................................................................ 22

Additional Tables and Illustrations ...................................................................................... 26


3

List of Tables

Table 1. Summary of 2015 DFAST and CCAR testing scopes (Ernst & Young

LLP, 2015) ..................................................................................................................... 11

Table 2. Comparison of elements of microprudential and macroprudential stress

tests (Greenlaw, Kashyap, Schoenholz, & Shin, 2012) ................................................. 26

Table 3. List of the banks which passed/failed the stress tests (Neretina, Sahin, &

de Haan, 2014) .............................................................................................................. 26

Table 4. List of all global SIFIs, as of Nov. 2014 (Financial Stability Board, 2014)

...................................................................................................................................... 27

Table 5. List of domestic SIFIs in the USA as of March 2014 (Board of Governors

of the Federal Reserve System, 2014) .......................................................................... 29

Table 6. Comparison of Dodd-Frank Stress Tests for Large and Mid-Size Banking

Organizations (Fei, 2014) .............................................................................................. 30

List of Figures

Figure 1. CCAR 2015 results for the major BHCs in the US (Deloitte Center for

Regulatory Strategies, 2015) ......................................................................................... 13

Figure 2. Overview of EU Stress Testing Outcomes in 2010-2014 (Steinhauser,

Enrich, & Colchester, 2014) ........................................................................................... 14

Figure 3. Sources of capital raised by the EU banks in Jan-Oct, 2014, EURbn

(Steinhauser, Enrich, & Colchester, 2014) .................................................................... 15

Figure 4. Breakdown of European banks' capital raising, by country, since July

2013, based on Morgan Stanley data (Steinhauser, Enrich, & Colchester, 2014) ......... 15

Figure 5. Breakdown of individual bank capital shortfall as of Oct. 2014 (Karaian,

2014) ............................................................................................................................. 16

Figure 6. Capital shortfall as of Oct. 2014 by countries, EURmln (Steinhauser,

Enrich, & Colchester, 2014) ........................................................................................... 17

Figure 7. Monthly outstanding loans to non-financial sector and year-to-year

growth rates in the Euro-zone, Jan 2007 Mar 2015, seasonally adjusted (European

Central Bank, 2015) ....................................................................................................... 17


4

Figure 8. Quarterly GDP and year-to-year growth rates in the Euro-zone, Q1-

2007 Q4-2014, at constant prices, seasonally adjusted (European Central Bank, 2015)

...................................................................................................................................... 18


5

Table of Abbreviations

AFMn Autoriteit Financile Markten (the Netherlands)

AMF Autorit des marchs financiers (France)

AQR Asset Quality Review

BaFin Bundesanstalt fr Finanzdienstleistungsaufsicht (Germany)

BdE Banco de Espaa (Spain)

BHC bank holding company

bn billion

CBRC China Banking Regulatory Commission

CCAR Comprehensive Capital Analysis and Review

CONSOB Commissione Nazionale per le Societ e la Borsa (Italy)

DFAST Dodd-Frank Act Stress Testing

EBA European Banking Association

ECB European Central Bank

EU European Union

EUR Euro

Fed Federal Reserve Bank

FINMA Financial Market Supervisory Authority (Switzerland)

FSA Financial Services Authority (UK)

FSAj Financial Services Agency (Japan)

FSMA Financial Services and Markets Authority (Belgium)

FSOC Financial Stability Oversight Council (USA)

G-SIB global systemically important banks

mln million

PPNR Pre-Provision Net Revenue


6

SCAP Supervisory Capital Assessment Program

SFAs Finansinspektionen (Sweden)

SIFI systemically important financial institution

USA, US United States of America

USD US dollar


7

This financial crisis was due to opacity and lack

of transparency in financial markets and regula-

tors who were asleep at the wheel. But now the

administration and the regulators have decided

to add liberally to the fog of opacity. Why call

them stress tests? Fudge tests would be a

truer description. Nouriel Roubini (2009)

Stress testing is a risk management tool nowadays regularly used by national

banking and financial regulators to assess the capacity of the largest bank holding com-

panies ability to weather financial and economic market turmoil and find out if they pos-

sess sufficient capital buffers to continue operations throughout such adverse periods.

Such testing also tries to see if the BHCs have robust, forward-looking capital-planning

processes that account for their unique risks. (Board of Governors of the Federal

Reserve System, 2014)

Capital adequacy ratios as a tool used in prudential bank regulation have been

used prior to the adoption of the first Basel Accords in 1988. Conversely, stress-testing

has a shorter history and historically was predominantly used in-house within banking

and financial institution as one of diverse array of risk management tools. In 2009, the

stress-testing techniques were introduced to system-wide risk management toolkit by

financial regulators in the US and EU. (Wall, 2014)

Stress Testing in Europe and the US: Overview

National bank supervision agencies expect banks to hold sufficient capital to cov-

er losses should adverse economic conditions occur. In this area, stress testing has be-

come one of the most important tools for bank supervisors to achieve that goal.

Greenlaw et al. (2012) distinguish two types of stress tests: microprudential and

macroprudential. Microprudential stress tests focus on preventing bank failures that re-

sult after bank equity meltdown. Here, bank capital is viewed as a buffer against losses

that takes hit before the deposit insurance agency gets hold of situation. Stress testing

procedures focus on Basel capital ratios, and stability and liquidity crises are motivating


8

events. At the same time, macroprudential stress tests view the banking system as inte-

grated unit where entire balance sheet capacity of BHCs supports the normal function-

ing of the wider economy. Per Greenlaw et al. (2012), the central goal of the testing is to

prevent or mitigate consequences of bank runs on system critical institutions by whole-

sale creditors, which might lead to loan volume contraction and damage to the broader

economy. According to the authors, results should include specific money amounts of

capital that should be raised rather than focus on mere satisfaction of capital ratios. The

summary of differences microprudential and macroprudential stress testing techniques

can be found in Table 2 in Additional Tables and Illustrations.

Another way that stress-testing designs may differ one from the other is their ob-

jectives, i.e. whether their results are intended for internal or external use. Stress testing

that is performed for internal decision making purposes are used to reflect the risk man-

agement culture of the organization. On the other hand, the results of the stress testing

exercise that are meant to be used externally should be well understood by the target

audience, i.e. regulators, authorities, investors and consumers. (Drehmann, 2008)

European and American regulators are pursuing similar goals when they conduct

stress testing of major BHCs, namely understanding their capacities to absorb financial

losses and through these preventing financial disturbances from negatively affecting ac-

tivities of other actors in a broader economy. At the same time, their approaches to the

stress testing process, design of such testing exercises and subsequently their focus

differ in each case.

Design of Stress Testing in the United States

In 2009, when the first stress tests were conducted in the US, the Fed had not

adopted Basel II as a framework in bank supervision. Therefore, between 2009 and

2014, the Fed was using a combination of Basel I with its amendments and a leverage

ratio with gross total assets in the denominator. Current stress testing procedure was

adopted due to the requirements of the Basel III which was adopted by the US bank su-

pervisor for the implementation in 2014 (Wall, 2014).

Nowadays, the US Federal Reserve is committed to using two measures to as-

sess capital adequacy and the degree of financial stability of the BHCs under its super-

vision. The Dodd-Frank Act introduced annual Dodd-Frank Act Stress Testing which


9

was meant to restore confidence in the US banking system in 2009 and is the scenario-

based stress testing exercise in the US. (Board of Governors of the Federal Reserve

System, 2014)

The scenarios are divided into base, adverse and severely adverse depend-

ing on the underlying projections. The base scenario aligns with general economic

forecasts for the US economic development throughout the testing period; adverse and

severely adverse scenarios are completely hypothetical and are developed purely to

test the rigidity of the banking system to withstand economic shocks (Board of

Governors of the Federal Reserve System, 2014).

The scenarios start in the 4th quarter of 2014 and extend to the 4th quarter of 2017

(i.e. they encompass 12 quarters in total). The set of 28 variables has stayed unchanged

compared to the last year stress-testing describing the economic conditions in the US

and abroad. The internal variables are divided as follows: six measures of economic ac-

tivity and prices, four aggregate measures of asset prices or financial conditions, and six

measures of interest rates. The international variables are grouped by countries or coun-

try blocs (i.e. four such groups) and describe three variables each: real GDP growth,

CPI change, and USD/local currency exchange rate. (Board of Governors of the Federal

Reserve System, 2014)

DFAST, a forward-looking component of the assessment procedures, is conduct-

ed by the Fed and financial companies under review. DFAST is used to assess if the

BHCs have enough capital to absorb losses and continue operations without disruptions

during adverse economic conditions while using historical capital actions of each BHC

(i.e. dividends or stock buy-backs). Complimentary to DFAST, Comprehensive Capital

Analysis and Review, an annual exercise, is carried out by the US Fed. According to the

methodology, the Fed analyses capital adequacy ratios, capital assessment processes

implemented by BHCs while taking into account capital action plans proposed by the

BHCs. As of 2014 reporting period, BHCs active in the US with assets less than

USD10bn were not subject to CCAR and DFAST procedures. (Board of Governors of

the Federal Reserve System, 2014). Based on the DFAST and CCAR results the Fed

can demand amending the capital action plans proposed by the bank or even turn them

down altogether. (Ernst & Young LLP, 2015)


10

31 BHCs participated in 2015 DFAST and CCAR (those BHC with assets be-

tween USD10bn and USD50bn were required to conduct DFAST only). Deutsche Bank

Trust Corporation is the only new BHC participating in CCAR/DFAST 2015 compared to

2014 stress-testing publication period. Nine participants with aggregate assets exceed-

ing USD50bn each were tested as members of the Large Institution Supervision Coordi-

nating Committee portfolio. These BHCs are Bank of America, BNY Mellon, Citigroup

(Citi), Deutsche Bank Trust Corporation, Goldman Sachs, JPMorgan Chase, Morgan

Stanley, State Street and Wells Fargo. The Fed has heightened expectations for capital

planning processes at these institutions relative to other CCAR participants due to their

size, complexity, and role in the wider economy. (Ernst & Young LLP, 2015) Such ex-

pectations translate into requirement to run company-designed stress-testing twice a

year. (De Ghenghi & Rohrkemper, 2015). For more information on how the DFAST

stress-testing approach differs between large and mid-size BHCs, please, refer to Table

6 in Additional Tables and Illustrations.

Design of Stress Testing in the European Union

The results for the latest Euro-zone stress-testing were published in October

2014. During this stress testing exercise, balance sheets of 130 BHCs across 18 coun-

tries and Lithuania1 with combined assets amounting to 85% of Euro-zones banking in-

dustry aggregate assets were scrutinized by the European Central Bank while national

regulators assisted in the process. At the same time, European Banking Association ran

tests on 123 banks in 28 countries across the EU. Parallel to stress-testing, Asset Quali-

ty Review took place to determine the value of the assets on the balance sheets, and it

was conducted by ECB and the national regulators. (Steinhauser, 2014). Within the

AQR, ECB examined 800 portfolios which represented ca. 57% of the banks risk-

weighted assets. This exercise included analysis of 119,000 borrowers and 170,000

pieces of collateral (Quinn, 2014).

As Steinhauser (2014) describes it, the EU stress-testing and AQR were de-

signed to detect banking institutions which risk weighted assets would fall below 8%

threshold should the economy develop as expected (during the latest stress testing ex-

ercise: until 2016). The crisis scenario envisaged a two-year recession combined with a

1 Lithuania was not a member of the Euro-zone at the time of testing but was to join the monetary

bloc as of January 1, 2015


11

market panic as experienced in the US after the collapse of Lehman Brothers. In this

case, the BHCs were to maintain a capital buffer of at least 5.5%.

Should a bank fail the test, within two weeks, its management had to come up

with a plan to increase BHCs capital buffer. The shareholders are incentivized to be one

of the primary sources of new capital; another option is selling excessive or risky assets

on the market. In case a BHC fails either AQR or stress tests baseline scenario, its

management has six months to implement the proposed plan. Those that fail only crisis

scenario are given nine months to increase the capital ratio. In severe cases, i.e. a capi-

tal hole is found on Systemically Important Financial Institutions balance sheet, a capital

increase plan is to be developed within one week. If the bank fails to increase its capital

ratio, the government or national agency has to step in, but only after the current share-

holders take a haircut. (Steinhauser, 2014)

Outcomes and Implications of the Latest Stress Testing

Stress-testing exercise in the USA was first conducted in 2009 and since then the

exercise was carried out annually, except for 2010 when it did not take place. The sum-

mary of the US stress tests in 2009-2013 is shown in Table 3 in Additional Tables and

Illustrations.

Latest DFAST and CCAR results were published on March 5, 2015, and March

11, 2015, respectively. The summary of what the scopes of 2015 DFAST and CCAR ex-

ercises is presented in Table 1 below:

Table 1. Summary of 2015 DFAST and CCAR testing scopes (Ernst & Young LLP,

2015)

DFAST 2015 CCAR 2015

Supervisory run Company run Supervisory run

Coverage 31 BHCs 31 BHCs 31 BHCs

Conducted by Fed BHC Fed

Models used Fed BHC Fed

Capital actions assumed Standardized per DFAST rules (historical dividends)

Standardized per DFAST rules (historical dividends)

BHC proposed capital actions

Analysis Quantitative Quantitative Quantitative and qualitative

Public disclosures Fed discloses summary of stress test results for superviso-ry severely adverse and adverse

Each BHC discloses summary of stress test results for super-visory severely adverse sce-

Objection or non-objection to BHC capital plans; Post-stress test capital ratios,


12

DFAST 2015 CCAR 2015

scenarios nario incl. planned actions, for se-verely adverse and adverse scenarios

Of the 31 banks that underwent the 2015 DFAST and CCAR testing, all institu-

tions successfully passed the scrutiny. The results of both simulation-based DFAST with

historical capital actions and the forward-looking CCAR showed that the lowest Tier 1

Common capital ratios were at the BHCs that have large investment banking and trading

activities (BHCs IB & Retail and Custodian on Figure 1) as the leverage ratios ap-

pears to be a binding constraint for these institutions (Ryan, Alix, Gilbert, & Meyer,

2015). At the same time, Ryan et al. (2015) notes that 2015 DFAST results indicated

that on average there is more Tier 1 Capital in the banking system now than it was be-

fore the stress-tests were introduced: 8.2% under the severely adverse scenario, which

is higher than the same banks pre-stress T1C average of 5.5% at the beginning of

2009.

Over the DFAST simulation period, total losses at the 31 BHCs under the severe-

ly adverse scenario were projected to reach USD490bn. At the same time, projected net

revenue before provisions for loan and lease losses (pre-provision net revenue, PPNR)

was projected to reach USD310bn, and net losses before taxes USD222bn. (Board of

Governors of the Federal Reserve System, 2015)


13

Figure 1. CCAR2 2015 results for the major BHCs in the US (Deloitte Center for

Regulatory Strategies, 2015)

Ryan et al. (2015) elaborates further on the outcomes of the recent stress testing

exercise in the US noting that total loan losses declined for the third time (to 6.1% down

from 6.9% in 2014 and 7.5% in 2013) which can be attributed to improved underwriting

standards as well as improving situation with the legacy credit portfolios. Additionally,

the banks under review have prepared to the possible Feds rate increase with only four

institutions not showing pre-tax profit over the nine quarters simulation period. Further

on, the authors add that the 2016 DFAST and CCAR will most likely be tougher for the

BHCs under review with Global Systemically Important Bank capital surcharge being ul-

timately factored into the stress testing process. Such change is driven by the criticism

that the Fed received for being too predictable.

The most recent European stress testing for 2013 published in October 2014 in-

dicated a cumulative capital shortfall of EUR24.6bn (or ca. USD31.2bn). The previous

stress-testing exercises in the Euro-area brought criticism for their lack of rigorousness

and failed to notice holes in capital structure of several banks. This one, however, was

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14

promised to bring real prudential supervision to the European banking industry. ECB

Executive Board member Joerg Asmussen also admitted that this stress-testing was the

last chance for the ECB to restore confidence in the industry and the ECB itself as its

supervisor. The ECB President Mario Draghi vowed to give failing marks to the BHCs

which would not stand the test. (Riecher & Black, 2013)

Since the test results showed capital deficit as of year beginning, most of it had

been already covered by October, and only EUR9.5bn was still outstanding. Figure 2

below shows how the 2014 results compare to the previously held stress tests in the EU.

The rising number of banks that failed the stress testing is attributed to the growing

number of institutions under scrutiny, on one hand, and to the growing rigorousness of

the test itself, on the other hand. This was done to show different stakeholders that the

financial stability of the European banking system was improving after the first stress

tests failed to take note of the upcoming difficulties at some of the institutions

(Steinhauser, Enrich, & Colchester, 2014). More on this issue will be presented in chap-

ter Criticism below.

Figure 2. Overview3 of EU Stress Testing Outcomes in 2010-2014 (Steinhauser,

Enrich, & Colchester, 2014)

Of the 25 failed banks, 12 institutions increased their capital buffers by the re-

ports publication date. Most of the capital (EUR25.9bn or ca. 73%) increase came in

form of new equity, according to data from Morgan Stanley (Steinhauser, Enrich, &

Colchester, 2014):

3 Capital shortfall does not take into account funds raised since Jan. 1, 2014

7

20

25

EUR3,5bn

EUR26,8bn EUR24,6bn

92,3%

77,8% 83,3%

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100%

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5

10

15

20

25

30

2010 2011 2014

Pass r

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UR

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No. of banks that failed Overall capital shortfall, EURbn Pass ratio


15

Figure 3. Sources of capital raised by the EU banks in Jan-Oct, 2014, EURbn

(Steinhauser, Enrich, & Colchester, 2014)

The distribution of BHCs that failed the test aligns with the countries that were

most affected by the aftermaths of sovereign debt crisis in the EU, i.e. most of such insti-

tutions were in Italy, Greece, Spain, Portugal, and Ireland, although presumably stronger

northern countries such as Ireland, Belgium, Germany, and Austria also saw some of

the failed banks. Given this, most of the capital raising took place in southern EU:

Figure 4. Breakdown of European banks' capital raising, by country, since July

20134, based on Morgan Stanley data (Steinhauser, Enrich, & Colchester, 2014)

4 Since banks started responding to the ECBs AQR

Equity issuance

25,9 73%

IPOs/ divestments

6.0 17%

Trading gains from

unwinding carry 3,7

10%


16

Among the 13 banks that had not increased their capital buffer by the stress-

testing reports publication date, the biggest problems were found with Italian, Greek and

Portuguese banks. Among the BHCs with uncovered holes in their capital structure was

Banca Monte dei Paschi which is Italys third-largest and has to come up with EUR2.1bn

of capital representing ca. 63.7% of all capital shortfall by the Italian lender as of Octo-

ber 2014. As for the Greek banks, Eurobank and National Bank of Greece although

failed, had no or practically no shortfalls taking into account capital already raised, the

ECB said. Dexia SA, which needed government bailout5 after the 2011 stress testing in-

dicated it had enough capital, is being wound down according to the plan approved by

the EU authorities in 2012 (Leighton-Jones & Hearon, 2014). For more details on the

capital needs exposed by the stress-testing outcome, please refer to Figure 5 and Fig-

ure 6 below:

Figure 5. Breakdown of individual bank capital shortfall as of Oct. 2014 (Karaian,

2014)

5 Under the restructuring plan, the BHC received EUR90bn of government guarantees from the

French, Luxemburg, and Belgian governments, the Belgian and French governments provided EUR6bn of public bailout funds; later in 2011 Belfius received another EUR4bn financial assistance from the Belgian government. It was split into two separate institutions of which Belgium-based resumed its banking opera-tions under the new name Belfius, and the Netherlands-based part of the BHC was set up as a bad bank (Treanor, 2011)

2 110

1 760

1 150

930

860

850

810

340

220

180

170

30

30

500 1 000 1 500 2 000 2 500

Banca Monte dei Paschi di Siena

Eurobank

Banco Comercial Portugues

National Bank of Greece

Volksbank

Permanent TBS

Banca Carige

Dexia

Banca Popolare di Vicenza

Hellenic Bank

Banca Popolare di Milano

Nova Kreditna Banka Maribor

Nova Ljubljanska Bank

Capital shortfall, EURmln


17

Figure 6. Capital shortfall as of Oct. 2014 by countries, EURmln (Steinhauser,

Enrich, & Colchester, 2014)

Whether the latest EU stress-testing was a success and brought back trust to the

banking industry in the Euro-zone, remains disputable. It should be noted, however that

the volumes of bank lending growth rates in the Euro-zone increased after the publica-

tion of the stress-testing results as indicated in Figure 7:

Figure 7. Monthly outstanding loans6 to non-financial sector and year-to-year

growth rates in the Euro-zone, Jan 2007 Mar 2015, seasonally adjusted

(European Central Bank, 2015)

6 Dark grey bars represent the months of publication of bank stress testing results

Italy; 3 310

Greece; 2 690

Portugal; 1 150

Austria; 860

Ireland; 850

Belgium; 340

Cyprus; 180

Slovenia; 60

(8,0%)

8,0%

16,0%

6 000 000

12 000 000

18 000 000

Jan-0

7

Apr-

07

Jul-07

Oct-

07

Jan-0

8

Apr-

08

Jul-08

Oct-

08

Jan-0

9

Apr-

09

Jul-09

Oct-

09

Jan-1

0

Apr-

10

Jul-10

Oct-

10

Jan-1

1

Apr-

11

Jul-11

Oct-

11

Jan-1

2

Apr-

12

Jul-12

Oct-

12

Jan-1

3

Apr-

13

Jul-13

Oct-

13

Jan-1

4

Apr-

14

Jul-14

Oct-

14

Jan-1

5

Y-t

o-Y

%-c

han

ge

EU

Rm

ln

Outstanding loans, EURmln Y-to-Y %-change


18

At the same moment, this growth may due to be economic stabilization of the

GDP growth in the Euro-zone: according to the ECBs data, after the 1st quarter 2013

the risk of W-shaped recession in the Euro-zone diminished as the growth rate picked

up from the anemic rates around 0% in 2012, as depicted in Figure 8. Given lending

volumes react to GDP growth rates with some time lag, such GDP dynamics could sig-

nificantly contribute to general situation in the banking sector.

Figure 8. Quarterly GDP and year-to-year growth rates in the Euro-zone, Q1-2007

Q4-2014, at constant prices, seasonally adjusted (European Central Bank, 2015)

Criticism

The observers, industry experts, and analysts have been vocal about the short-

comings of the stress-testing exercises both in the US and the EU since the financial

check-ups were introduced in 2009, with most criticism addressing the EU stress tests

due to their unreliable results in the past. (Hardy & Hesse, 2013)

Kashyan et al. (2012) argue that stress testing exercises both in the US and the

EU fail to determine the rigidity of the whole banking system to weather sudden eco-

nomic and financial downturns as they concentrate on balance sheets of individual

banks in isolation while ignoring potential spillover effects within the whole system. The

authors go ahead to note, that banking regulators during stress testing concentrate on

the common capital levels while they ignore the main source of balance sheet financing

being wholesale bank financing. Compared to common equity, wholesale financing is

more volatile and can be withdrawn by the creditors should they sense increasing mar-

ket risks forcing banking institutions to fire sell their assets to deleverage balance

(8,0%)

(6,0%)

(4,0%)

(2,0%)

2,0%

4,0%

6,0%

8,0%

2 000 000

2 250 000

2 500 000

2 750 000

3 000 000

Q1-2

007

Q2-2

007

Q3-2

007

Q4-2

007

Q1-2

008

Q2-2

008

Q3-2

008

Q4-2

008

Q1-2

009

Q2-2

009

Q3-2

009

Q4-2

009

Q1-2

010

Q2-2

010

Q3-2

010

Q4-2

010

Q1-2

011

Q2-2

011

Q3-2

011

Q4-2

011

Q1-2

012

Q2-2

012

Q3-2

012

Q4-2

012

Q1-2

013

Q2-2

013

Q3-2

013

Q4-2

013

Q1-2

014

Q2-2

014

Q3-2

014

Q4-2

014

Y-t

o-Y

%-c

han

ge

EU

Rm

ln

Eurozone GDP, EURmln Y-to-Y %-change


19

sheets, and consequently leading to domino effect as asset prices decline which affects

all market players.

Goldstein (2014) suggests that the ECB and EBA scrap the risk-weighted assets

as a base measure used in stress testing since it proved to be a less predictable meas-

ure of bank failure in the future. Unweighted leverage ratios are already used in the US

and the UK bank stress testing and have proved their usefulness. Furthermore, before

the 2007-2009 financial crisis, risk weighted measures indicated that banks were well-

capitalized in contrast to the unweighted measures. However, at the same time, Gold-

stein stresses that EU regulators should not completely rely on the US approach to

stress testing and the requirements that the Fed has developed for the BHCs under its

supervision: the EU banking system is more concentrated than the US one, and there-

fore European banks need to hold higher capital cushions compared to their US coun-

terparts.

Some observers have also criticized accounting tricks that the BHCs employ to

hide the magnitude of their risk exposure. There is a significant room for balance sheet

optimization according to Alberto Gallo, head of European macro credits at Royal Bank

of Scotland, and the bigger the BHC the better it can conceal risky assets (Thompson

& Ross, 2014). Alberto Gallo adds further: There is almost an inverse relationship be-

tween the size of banks and how much regulatory risk they declare some large in-

vestment banks have optimized their models over time to show their assets are less

risky. For example, Deutsche Bank in its 2012 annual financial report has managed to

present EUR55.605 trillion of derivative exposure7 via first displaying net values on as-

sets side amounting to EUR776.7bn and on liabilities side to EUR756.4bn, which in the

end netted each other to the amount of EUR20.3bn. (Durden, At $72.8 Trillion,

Presenting The Bank With The Biggest Derivative Exposure In The World (Hint: Not

JPMorgan), 2013)

Another point of criticism is the how the results of stress testing are used by the

BHCs shareholders. Should a given bank pass the test, such result effectively allows

distribution of dividends regardless of how much better than the threshold were the re-

7 The aggregate deposits of the Deutsche Bank are ca. 100 times smaller, and this amount is ca.

20 times larger than the entire 2012 GDP of Germany, as Germany Trade & Invest indicates (Business Briefing: Germany, 2014)


20

sults. For example, in 2007 the US supervisors allowed distribution of dividends amount-

ing to USD80bn by 19 banks which in 2009 were subject to Supervisory Capital As-

sessment Program. This amounted roughly to half of the total public funds injected in

these institutions in the form of recapitalization later. (Greenlaw, Kashyap, Schoenholz,

& Shin, 2012)

Last but not the least important point of criticism is the stress-testing scenarios

which in some respects envisage mild or short-living recessions. For example, the ECB

did not include deflation in its set of scenarios even though the Euro-zone was about to

be in deflation according to statistical data (Durden, 2014). The Feds 2014 DFAST sce-

narios envisaged relatively swift return to economic growth as well as Dow-Jones Indus-

trial Index returning to record high levels within 9 quarters (Durden, 2015).

Conclusions

In this paper, I tried to outline the way stress testing as regulatory risk manage-

ment and prudential tool has been implemented in the US and the Euro-zone. Although,

both approaches have much in common, there are important differences between the

two. There is also a lot to improve in both stress-testing methodologies, if the regulators

are determined to make stress-testing an effective tool in a macroprudential supervisory

arsenal. Currently, due to various reasons most improvements are to be developed and

implemented by the ECB, the EBA, and the newly set-up Single Supervisory Mechanism

and European Systemic Risk Board which together will coordinate and conduct banking

stress testing in the EU.

The evolution of the stress testing throughout the past years revealed several

weak points that should be addressed in the near future. Some of the major points have

been covered in the section Criticism of this paper. At the same time, as forward-looking

prudential exercise, the future generations of the stress testing should seek to address

not only issues that ignited the 2007-2009 financial crisis, but also the challenges that

will shape the development of the banking industry in the future.

First off, the regulators have to re-assess the required minimum capital to be

maintained by the banking institutions. As Goldstein (2014) suggests, the required capi-

talization levels everywhere are too low. He further refers to the broad support by the


21

leading financial academics who propose that the new level of leverage ratios should be

15% which is substantially higher than the 3% proposed by the Basel lll; achieving such

a target would generate substantial social benefits with minimal social cost.

In the midterm, the bank regulators should re-focus their attention on liquidity and

funding stress testing, especially in the context of the phasing in of detailed common re-

porting templates on maturity mismatches, cost of funding, and asset encumbrance

(Hardy & Hesse, 2013). Future stress-testing scenarios should also incorporate more

long-term factors and generate lessons that relate more to structural issues. The worlds

financial system faces a prolonged period of low interest rates, possibly low growth, in-

creased regulatory burdens under Basel III and in Europe also Capital Requirement Di-

rective IV, demographic change as well as structural changes in employment patterns

(i.e. higher share of part-time, temporary and freelance workers) in developed countries.

These developments will put pressure on profitability, the supply of savings, industry

competition, etc. Therefore, the stress test scenarios need to encompass a longer time

horizon, incorporate structural shifts (e.g. ongoing deleveraging and changes of bank

funding profiles) affecting the balance sheet and income. (Hardy & Hesse, 2013)


22

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26

Additional Tables and Illustrations

Table 2. Comparison of elements of microprudential and macroprudential stress tests (Greenlaw, Kashyap,

Schoenholz, & Shin, 2012)

Item of comparison Microprudential Macroprudential

Purpose The goal is to value bank assets correctly and determine that adequate

loss-bearing capacity is in place to protect taxpayers from having to bail

out insured deposits

The goal is to limit the likelihood and costs of aggregate fire sales, credit

crunches and defaults

Scope Analyze one bank at a time, or use data from multiple banks to over-

come imperfect information about the value of individual bank assets

The test examines the entire financial system. Any entity that contrib-

utes to fire sales, whose default has follow-on effects, or which can

exacerbate a credit crunch should be included

Liability Considerations Count the amount of insured deposits and the amount of junior debt

and equity. The required loss absorbency is calculated as a ratio rela-

tive to asset risk.

Because a run can lead to a credit crunch or fire sale, the scale of

wholesale funding that is run-prone is paramount. Capital adequacy

depends on the health of the overall financial system

Asset Considerations Credit risk of different assets determines enterprise risk, so loss absor-

bency of liabilities is tied to asset composition. A capital ratio therefore

naturally emerges as a basis for supervision

Asset liquidity is critical, because illiquid assets can contribute to fire

sales. Asset risk depends both on default risk and fire sale risk

Output Develop guidance about whether to close a bank and when to sell its

assets to maximize taxpayer recovery

The test indicates whether the financial system is vulnerable to delever-

aging that might amplify adverse shocks

Table 3. List of the banks which passed/failed the stress tests (Neretina, Sahin, & de Haan, 2014)

Bank Holding Companies 2009 2012 2013

DFAST 2013

CCAR US SIFI status in 2014

Ally Financial - - - - d

American Express + + + - d

Bank of America - + + + g

Bank of New York Mellon + + + + g


27

BB&T + + + - d

Capital One Financial + + + + d

Citigroup - - + + g

Fifth Third Bank - + + + d

Goldman Sachs + + + - g

JPMorgan Chase + + + - g

KeyCorp - + + + -

MetLife + - n.a. n.a. -

Morgan Stanley - + + + g

PNC Financial Services - + + + d

Regions Financial - + + + d

State Street + + + + g

SunTrust Banks - - + + d

U.S. Bancorp + + + + d

Wells Fargo - + + + g

Total assessed BHCs 19 19 18 18

No. of failed BHC 10 4 1 5

Pass rate 47.4% 78.9% 94.4% 72.2%

Notes: This table presents the list of the banks which passed/failed the 2009-2013 stress tests. + means that a bank passed the stress test without any frictions (No-Gap banks), and - indi-cates that a bank had a capital gap or did not receive approval for capital distributions (Gap banks). n.a. denotes that the bank did not participate in the corresponding testing procedure. g/d denotes that the bank is a global/domestic SIFI according to the Financial Stability Board (FSB, 2013).

Table 4. List of all global SIFIs, as of Nov. 2014 (Financial Stability Board, 2014)

Entity Region HQ country HQ currency HQ regulator Major exchange(s) Notes

Mizuho FG Asia Japan Yen FSAj TYO, NYSE

Sumitomo Mitsui Asia Japan Yen FSAj TYO, NYSE

Mitsubishi UFJ FG Asia Japan Yen FSAj TYO

Bank of China Asia China Renminbi CBRC SEHK, SSE Majority state owned

ICBC Asia China Renminbi CBRC SEHK, SSE Majority state owned

Agricultural Bank of China Asia China Renminbi CBRC SEHK, SSE Majority state owned

Dexia Group Europe Belgium Euro FSMA Euronext Resolution was ordered Oct 2011. Dexia Bel-


28

gium was bought out from the group by the Belgian state, and continues to exist as Belfius. Remaining part of the group was left in a "bad bank" to be liquidated.

BNP Paribas Europe France Euro AMF Euronext

Crdit Agricole Europe France Euro AMF Euronext

Banque Populaire CE Europe France Euro AMF cooperative

Socit Gnrale Europe France Euro AMF Euronext

Commerzbank Europe Germany Euro BaFin XETRA, FWB Of declining systemic importance

Deutsche Bank Europe Germany Euro BaFin FWB, NYSE

Unicredit Group Europe Italy Euro CONSOB BIT, FWB

ING Bank Europe Netherlands Euro AFMn Euronext, NYSE

Banco Bilbao Vizcaya Argentaria Europe Spain Euro BdE BMAD, NYSE

Santander Europe Spain Euro BdE BMAD, LSE, NYSE

Nordea Europe Sweden Swedish Krona SFAs OMX

Credit Suisse Europe Switzerland Swiss franc FINMA SIX, NYSE

UBS Europe Switzerland Swiss franc FINMA SIX, NYSE

Royal Bank of Scotland Europe United Kingdom British pound FSA LSE, NYSE

Barclays Europe United Kingdom British pound FSA LSE, NYSE

HSBC Europe United Kingdom USD FSA LSE, NYSE, Euronext, SEHK

Lloyds Banking Group Europe United Kingdom British pound FSA LSE, NYSE Of declining systemic importance

Standard Chartered Europe United Kingdom British pound FSA LSE, SSE, NSE

Bank of America Americas USA USD FSOC NYSE

Bank of New York Mellon Americas USA USD FSOC NYSE

Citigroup Americas USA USD FSOC NYSE

Goldman Sachs Americas USA USD FSOC NYSE

JP Morgan Chase Americas USA USD FSOC NYSE

Morgan Stanley Americas USA USD FSOC NYSE

State Street Americas USA USD FSOC NYSE

Wells Fargo Americas USA USD FSOC NYSE, BMV, FWB


29

Table 5. List of domestic SIFIs in the USA as of March 2014 (Board of Governors of the Federal Reserve System, 2014)

Entity Region HQ country HQ currency HQ regulator Major exchange(s) Notes

Ally Financial Americas USA USD FSOC Non-public Previously owned by GMAC, now 73% owned by the US government

American Express Americas USA USD FSOC NYSE

BB&T Americas USA USD FSOC NYSE

BBVA Compass Americas USA USD FSOC Subsidiary Subsidiary of BBVA

BMO Financial Corp. Americas USA USD FSOC Subsidiary Subsidiary of Bank of Montreal

Capital One Financial Americas USA USD FSOC NYSE

Comerica Americas USA USD FSOC NYSE

Discover Financial Services Americas USA USD FSOC NYSE

Fifth Third Bank Americas USA USD FSOC NASDAQ

HSBC North America Holdings Americas USA USD FSOC Subsidiary Subsidiary of HSBC Holdings

Huntington Bancshares Americas USA USD FSOC NASDAQ

KeyCorp Americas USA USD FSOC NYSE

M&T Bank Americas USA USD FSOC NYSE

MetLife Americas USA USD FSOC NYSE

MetLife Bank failed the stress test in 2012, and as a consequence sold its banking unit to GE Capital and its USD70bn mortgage servicing business to JPMorgan Chase

Northern Trust Americas USA USD FSOC NASDAQ

PNC Financial Services Americas USA USD FSOC NYSE

RBS Citizens Financial Group Americas USA USD FSOC Subsidiary Subsidiary of Royal Bank of Scotland

Regions Financial Americas USA USD FSOC NYSE

Santander Holdings USA Americas USA USD FSOC NYSE / Subsidiary Subsidiary of Santander Group

SunTrust Banks Americas USA USD FSOC NYSE

U.S. Bancorp Americas USA USD FSOC NYSE

UnionBanCal Americas USA USD FSOC Subsidiary Subsidiary of Mitsubishi UFJ FG

Zions Americas USA USD FSOC NYSE, NASDAQ


30

Table 6. Comparison of Dodd-Frank Stress Tests for Large and Mid-Size Banking Organizations (Fei, 2014)

Large BHCs ($50 billion in total consolidated assets)

Mid-size BHCs (>$10 billion and < $50 billion in total consolidated assets)

General Stress Testing Requirements

Large bank holding companies (BHCs) must participate in Federal Reserves annual Compre-hensive Capital Analysis and Review (CCAR) exercise

Mid-size BHCs do not participate in CCAR

Large BHCs are subject to annual supervisory stress tests: Mid-size BHCs are not subject to supervisory stress tests

- Federal Reserve publicly discloses summary results of supervisory stress tests

Large BHCs must submit annual capital plans to Federal Reserve: Mid-size BHCs are not subject to Federal Reserves capital plan rule:

- Subject to Federal Reserve approval of results, capital plan and capital actions - No required minimum post-stress capital ratios

- Must maintain > 5% post-stress Tier 1 Common ratio - No formal supervisory approval associated with stress testing

- Must use both supervisory and BHC-specific stress test scenarios - Only required to use supervisory scenarios in Dodd-Frank company-run stress tests

Dodd-Frank company-run stress test:

- Semi-annual submissions by January 5th

and July 5th of each year - Annual submission by March 31

st of each year

- Report on form FR Y-14A - Report on form FR Y-16

- Semi-annual public disclosures of summary results (March and September) - Annual public disclosure of summary results beginning in June 2015

Incorporation of U.S. Basel III into stress testing:

- Must incorporate U.S. Basel III capital framework in capital projections - Not required to incorporate U.S. Basel III capital framework in capital projections until

the 2015 stress testing cycle starting in October 2014

- Tier 1 Common ratio is calculated using existing capital rules - Not required to calculate Tier 1 Common ratio for 2014 stress testing cycle

Dodd-Frank Stress Test Reporting Requirements

Form FR Y-14A for large BHCs: Form FR Y-16 for mid-size BHCs, state member banks (SMBs) and savings and loan holding companies (SLHCs):

- Annual and semi-annual (mid-cycle) submission - Annual submission

- Approximately 2,500 line items per scenario for annual and 1,900 for semi-annual (mid-cycle) submission

- Summary report with approximately 100 line items per scenario


31

FR Y-14Q for supervisory stress test:

- Quarterly submission - Not applicable

- Loan-level data collected

FR Y-14M for supervisory stress test:

- Monthly submission - Not applicable

- Loan-level data collected

Federal Reserves Minimum Supervisory Expectations for Dodd-Frank Stress Tests

Stress test scenarios:

- Large BHCs must develop BHC-specific scenarios to stress key vulnerabilities and identify idiosyncratic risk drivers

- Not required to develop own scenarios

Data sources and segmentation:

- Proxy data acceptable, but generally expected to use internally generated data - May use industry data as a proxy under certain conditions

- Data segmented at least as detailed as FR Y-14A (approximately 2,500 lines per sce-nario)

- Data segmented by FR Y-16 (approximately 100 lines per scenario) and largely re-flects Call Report and FR Y-9C report

Loss estimation:

- Identify key loss drivers; indicate how the scenarios affect those drivers and losses - May choose to base their stress losses on industry historical loss experience

- More granular loss estimation expectations using FR Y-14A segmentation - May be able to estimate credit losses on an aggregate level (top-down approach) us-

ing FR Y-16 segmentation

Operational losses:

- Expected to include operational loss estimates - Include aggregate operational losses in Pre-Provision Net Revenue (PPNR) only if di-

rectly related to macroeconomic and financial scenarios provided by supervisors

Pre-Provision Net Revenue (PPNR) Model:

- Granular estimation approach - Less granular top of the house approach

- Use internal revenue and expense data to estimate business lines revenues and ex-penses

- Project PPNR based on three main components (net interest income, noninterest in-come and noninterest expense)

- Identify specific drivers of revenue and expenses and analyze how supervisory scenar-ios affect those drivers

- Can project at an aggregate, company-wide level, and may be based on industry expe-rience


32

Balance sheet and risk-weighted assets:

- Projections for each major segment of the balance sheet for FR Y-14A - In some cases, may use a simple, constant method for projecting full balance sheet

and risk weighted assets

Controls, oversight and documentation:

Must be an integral part of preparing and submitting capital plan and the resolution and recov-ery planning process

Must consider the role of stress testing results in the normal course of business (e.g., capital planning, assessment of capital adequacy and risk management)

Stress Testing Financial Stability

Documents

design of stress testing

latest stress testing

list of tables table

history of stress

frank stress tests

stress tests neretina

table of abbreviations

contents list of tables