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The FSA welcomes the publication of the results of the EU-wide stress test exercise conducted by the Committee of European Banking Supervisors (CEBS). The CEBS exercise shows that the UK banks are well placed to handle further periods of economic stress, as outlined in the macro economic parameters detailed by CEBS, should such stress develop.
The purpose of a stress test is to understand the extent to which banks are prepared, should the economic environment take a turn for the worse. It is not a prediction of what will happen or what banks' results will actually be and the CEBS stress test does not take into account actions a bank might take in response to deteriorating economic conditions. It would be misleading therefore to treat the results of the stress test as a forecast either by the FSA or the individual banks.
CEBS stress testing framework
The objective of the CEBS exercise is to undertake an assessment of the strength of EU banks in a consistent manner across institutions and countries. It focused on three different scenarios; a benchmark stress, a more adverse macro-economic stress and a country-wide stress.
The benchmark stress identifies movements in parameters such as GDP, unemployment and interest rates and charts a mild deviation away from the pathway which the economy is currently on: it then makes conservative assumptions about the loan losses which will result in this macro-economic scenario. This helps to set a benchmark (mildly stressed scenario) against which the more adverse stress is then applied. The adverse stress assumes a 3 percentage point deviation of GDP for the EU compared to the European Commission’s forecasts over the two-year time horizon. The method of translating this scenario to loss rates is also conservative.
A further ‘sovereign stress’ was then applied. This tested the resilience of banks to an increase in the yields of government bonds issued by EU member states. It simulates, (i) the associated medium term uptick in household and corporate sector loan losses in the banking book, and (ii) immediate mark to market losses arising from trading book holdings of government bonds of each country. The actual exposures of each bank to central and local government across the EU have been published by each bank.
Results identify the simulated Tier 1 ratios of European banks as well as specific simulations for profit and loss measures. The CEBS results are focused on Tier 1 ratios for comparability across the EU.
As expected the outcomes of the stresses demonstrate the preparedness and resilience of the UK banks under unlikely adverse economic scenarios. The FSA has published the high level results for the UK banks. This resilience is a result of the considerable work that has been undertaken to strengthen UK banks in recent years. The CEBS stress test is different but complementary to the FSA’s stress testing regime.
FSA’s stress testing regime
The UK banks are required to meet the FSA’s interim capital regime introduced in November 2008. This requires them to be able to meet a severe stress over a forward looking period exceeding 4% Core Tier 1 at all times. The UK introduced a tougher definition of Core Tier 1, including the deduction of intangibles such as goodwill, in 2008 so Core Tier 1 ratios cannot be compared across countries. This takes the UK definition in the direction of current proposals from the Basel Committee (4% is double the existing Basel minimum). Present Core Tier 1 ratios are well in excess of this level.
The FSA’s stress tests used in this regime are tailored to each individual bank and are embedded in the FSA’s ongoing supervisory process on a rolling basis. The FSA published in February 2010 the macro-economic parameters to be used in stress tests conducted during 2010, and will in the future publish each year the updated macro-economic parameters.
Supplementary information regarding the assumptions in the CEBS exercise
The following additional information may be useful in understanding the assumptions and interpreting the CEBS results:
Static balance sheet - a key assumption of the CEBS exercise is that of a static balance sheet. This means that it takes the position of the balance sheet - primarily the size of a bank's loan book - at the 2009 level and assumes it will stay at that level for two years. This assumption limits growth in retail and commercial banking revenue in the benchmark and stress scenarios. There is no allowance for pre-agreed strategies, such as changing the business profile, nor does it take account of the types of actions banks might take in response to a macro economic shock such as reducing risk profiles and shrinking the balance sheet.
Consistent assumptions - CEBS provided benchmarks for the probabilities of default (PDs) and loss-given default (LGDs) which might occur in stress scenarios. These benchmarks increase the consistency of results, which is an important objective in a large multi-country exercise. But it inevitably means that some relevant specific features of individual bank exposures cannot be reflected in the way which is possible when in-depth individual bank stress-tests are conducted.
Separate assumptions were provided by CEBS for each of the EU member states and the USA; in addition, a single set of assumptions was used to model the scenario impact for the ‘Rest of the World’. For some banks this is inevitably a major simplification.
Potential double counting - in order to achieve a conservative and consistent approach some losses may have been double counted. For example, the losses captured by the trading book stress in the adverse scenario may also materialise in reduced income from trading, which is factored into assumptions on earnings.
Interpreting the limitations - the limitations of the static book approach and other simplifying assumptions necessary in this pan EU exercise, mean that the results, whilst informative, are not forecasts and should only be understood as a guide to the resilience of the banks in adverse circumstances.
Background
- The FSA has previously published the following in relation to stress testing and relevant capital ratios:
- FSA Statement on Capital Approach Utilised in UK Bank Recapitalisation Package (14 November 2008)
- FSA statement on its use of stress tests (28 May 2009)
- FSA strengthens stress testing regime (11 December 2009)
- FSA Financial Risk Outlook updates stress test macro-economic variables (page 27) (10 March 2010)
- FSA Statement on regulatory approach to bank capital (19 January 2009)
- Tier one capital consists predominantly of equity share capital but may also include some forms of higher quality hybrid capital.
- The FSA regulates the financial services industry and has five objectives under the Financial Services and Markets Act 2000: maintaining market confidence; promoting public understanding of the financial system; securing the appropriate degree of protection for consumers; fighting financial crime; and contributing to the protection and enhancement of the stability of the UK financial system.
