ESBG calls to maintain, improve a single-leg stress test
>> Read ESBG response to EBA discussion paper
>> See EBA consultation webpage (off-site)
BRUSSELS, 6 July 2020 – ESBG welcomes the European Banking Authority (EBA) initiative to revise and re-centre the EU-wide Stress Testing framework, it said on 30 June in a reply to the EBA consultation on an authority discussion paper that tackles future changes to the EU-wide stress test. ESBG said it hopes that any changes to the framework will result in increased transparency and simplicity of the overall process.
Changing the current framework as described in the EBA discussion paper may however not bring additional benefits and risks reducing some of the advantages of the existing process. The different results of the supervisory and bank legs, as proposed in the EBA discussion paper, would in all probability increase costs, complexity and quality assurance requirements. ESBG would therefore encourage the EBA to continue future stress tests with only a single-leg. The current approach has its merits, as banks are tested against a common methodology and, as stated in the discussion paper, the main benefit of undertaking stress tests in such a coordinated fashion is the production of transparent and comparable outcomes. This would also allow to focus on improving the existing methodology and removing or relaxing constraints that do not have sensible impacts. To mitigate costs and increase benefits from future EU-wide stress tests, ESBG says the EBA should preferably consider improvements to the existing and already-known processes of the established stress test governance, procedure and methodology.
Think about costs
ESBG says EBA should considered costs for developing a two-leg stress test approach,. The balance between relevance on the one hand and cost-efficiency on the other, in fact, do not appear to be well balanced within the proposed two legs exercise. To mitigate costs and increase benefits from future EU-wide stress tests, the EBA should rather consider improvements to the existing and already-known processes of the established stress test governance, procedure and methodology. Place particular focus on improving process efficiency.
Communication of test results and disclosure: need simplified rules
On communication of stress test results and disclosure, we believe granularity of disclosures too high. The current disclosures for the EBA stress test deem to be sufficient and also acknowledged by all relevant stakeholders next to competent authorities and banks such as analysts, investment banks and rating agencies. In case the bank leg will be implemented, this introduces the risk that relevant stakeholders might misinterpret the results publication and much more Q&A and explanation work will be needed from both banks and regulators. The level of detail of the transparency templates also too high, it should be reduced. Along with maintaining a single-leg stress test, the regulatory authorities should rather implement simplified rules on banks' communication of results and improvements to the existing methodology. Allowing banks to communicate concerns regarding top-down methodologies and constraints along with supplementary information where the banks deem necessary.
Furthermore, supervisory involvement in the bank leg would lead to a duplication of the efforts. Any deviation of the starting points will be enforced via market discipline in the publication, with explanations required by market analysts. Explaining deviations from the proscribed methodology will require clear and concise communication by the banks when publishing the bank leg. This will also mean that banks being required to comment on the results of the supervisory leg, which poses a challenge due to the limited disclosure of supervisory models.
Pillar 2 Guidance disclosure: Perhaps counterproductive to market valuations
Pillar 2 Guidance (P2G) is a recommendation made by the supervisor in a case by case basis with no need to publish it since it lacks being a requirement. If P2G is published, analysts may consider it as a requirement and push banks to comply with it earlier than expected. It would have therefore a counterproductive effect from the point of view of market valuations, particularly towards listed banks. Before considering P2G publication, it should be made clear to banks and to the market how the stress-test outcome feeds into P2G. Then, it will be necessary to ensure that the market has a full understanding that P2G is not a requirement and that its use does not result in a trigger of any Minimum Distributable Amounts (MDA) restrictions.
Management actions: voluntary publication
In ESBG's view, communication of management actions on the capital position are rather critical as they might be perceived as credit-negative by analysts and rating agencies. Especially if such actions do not fully reflect external stakeholders' expectations. Public communication of such actions should be done on a voluntary, case-by-case basis.
Single, well-calibrated scenarios can fulfil the purposes of two separated scenarios
Finally, regarding the feasibility of introducing changes to the scenarios' design, ESBG sees limited benefits and many costs when implementing two adverse scenarios. Performing two adverse stress test calculations would lead to material increase in efforts both for the banks and for supervisors during the Quality Assurance (QA) process. Changing to two scenarios would also broaden the complexity of communication to explain the results towards external stakeholders. Having two adverse scenarios will still not be sufficient to fully cover the risk profiles of all the EU banks due their heterogeneity of business models, clients and geographies. Single, well-calibrated scenarios can fulfil the purposes of two separated scenarios, therefore we would suggest keeping one scenario only.
About the discussion paper
The discussion paper aims to present the EBA vision of the future for EU-wide stress test and to collect comments and feedback from the different users. The EBA proposal envisages two components owned by supervisors and banks respectively: the supervisory leg and the bank leg. The supervisory leg serves as the starting point for supervisory decisions and would be directly linked to the setting of P2G. The bank leg, on the other hand, allows banks to communicate their own assessment of risks in an adverse scenario.