The European Banking Authority has published the final methodology and scenarios (baseline and adverse) for its 2016 stress test.
The test will cover 51 EU banks, representing 70 percent of the EU banking sector. The European Central Bank (ECB) and the Prudential Regulation Authority (PRA) will oversee completion of the stress tests for the banks that fall under the jurisdiction of the Single Supervisory Mechanism (SSM) and UK banks respectively.
The three-year adverse scenario is broadly comparable to the 2014 adverse scenario:
In addition to assessing the impact of this scenario on profitability through the standard transmission mechanisms, banks will have to consider the impact of higher funding costs and the credit and FX risks on loans denominated in foreign currencies.
There is no “pass mark” for the test, but supervisors will address perceived capital shortfalls through Pillar 2 capital. The ECB and PRA have also stated that governance, procedures and data quality issues will be reflected in Pillar 2 (following the Federal Reserve’s focus on these more qualitative aspects in recent US stress tests).
The test takes no account of IFRS 9, which is the subject of separate EBA and ECB work-streams.
The final methodology no longer requires banks to re-calculate VaR figures using risk factors provided by supervisors, which would have created acute modelling challenges, while some clarifications regarding CVA charges and counterparty credit risk may also be helpful to banks.
The timetable will be challenging: