Lessons from the ECB June 2020 stress tests
In June 2020, the European Central Bank/ Single Supervisory Mechanism (ECB/SSM) conducted a stress test exercise known as “Vulnerability Analysis” for 86 EU banks considered as systemically important. Three scenarios were used:
- Macroeconomic forecasts made at the end of 2019;
- Forecasts published by the ECB in June 2020;
- The possibility of a deep and lasting recession.
At the end of July, the ECB/SSM published the results in an aggregate basis, without disclosing the results by country. Their findings suggest that the EU banking system is expected to experience an aggregate capital ratio loss of 1.9 percentage points in the central scenario and a more significant impact of around 5.7 percentage points in the case of a more severe scenario than the forecasts for 2020. In this commentary Fourel et al. warn that these stress tests:
[A]re thus more akin to forecasting exercises (i) with a highly uncertain economic recovery scenario and (ii) a methodology that is entirely based on the supervisory authorities’ models and does therefore not involve banks. In these “top-down” exercises, banks’ individual characteristics are less well integrated and further work is needed to possibly calibrate individual requirements in terms of capital strengthening.
Bank stress-tests at the time of Covid-19
By: Valère Fourel, Julien Idier, Valerio Scalone and Aurore Schilte – Banque de France
Lessons from the U.S. 2020 stress tests
In this paper, Agarwal and Goel build a tractable three-period model of stress-test based bank capital regulation under information asymmetry: the banks take household deposits and invest them in risky projects whose returns can be either high or low depending on the bank’s type. To mitigate the negative effects from bank overborrowing, a baseline minimum capital-ratio requirement is imposed as regulators cannot observe the type of each bank.
They use the Covid-19 crisis as a natural experiment to assess stress-testing and show that banks’ performances in the 2020 U.S. stress-test (which took place before the crisis) and during the crisis are highly discordant, both in absolute and relative (cross-sectional) terms. In particular, they find:
- Some of the worst performers in the test actually raised their CET1 ratios during the crisis;
- Technical and computational glitches can lead to faulty results. As such, stress-tests may exhibit Type-I and Type-II errors, as a result of which a less (more) risky bank may fail (pass) the test and face excessive (insufficient) regulation;
- Inaccurate results can have a large impact on banks’ capital costs, on their operations, and on overall economic welfare.
Limits of stress-test based bank regulation: Cues from the Covid-19 crisis
Authors: Isha Agarwal, Tirupam Goel
From: University of British Columbia, BIS
