THE BANKS PASSED – BUT THE STRESS TEST IS FAILING

Damon Batten, Catalyst Development Ltd www.catalyst.co.uk

On the 26th October, the European Banking Authority (EBA) published the results of its latest stress testing exercise, assessing the resilience of the European Union’s 123 largest banks. Despite 25 of those banks failing the stress test, and an aggregate capital shortfall of €24.6bn being identified, investors seem to have taken some comfort from these results – with markets seen to rally modestly from recent lows.

However, good stress testing data, and indeed all risk data, needs to be timely, to enable good decision-making. Unfortunately, the balance sheet data on which the EBA exercise is based is far from timely. The massive 10 month gap between the balance sheet used and the publication date is indefensible, if these results are really supposed to offer an accurate view of either current health or future stability.

A great deal can change in a ten month period – banks’ balance sheets are likely to have been significantly transformed, changing their level of exposure to the stresses applied, and the scenarios used will have become less relevant, as conditions in the broader economy continue to evolve. Until banks and regulators can work together to produce these results faster, it is even more crucial that the scenarios chosen are relevant and forward looking as regards the macroeconomic factors at play. The lack of deflationary scenarios in EU stress testing was a severe oversight.

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For evidence of the impact of these factors, you only need to look back as far the previous 2011 stress testing exercise. Both Dexia and Bankia were seen to pass, with no issues identified, yet both went on to fail spectacularly shortly after the results were published.

The conclusion? Without a proper understanding of the context, the results of the latest EBA stress tests are dangerously, deeply misleading. It is clear both the banks and the regulators need to raise their game.

The banks must raise their game

Timeliness is key to the usefulness of the stress testing results, and one key impediment to delivering timely information is likely to be theindividual bank’s own ability to run the test and report the results. Risk calculation, aggregation and reporting capabilities will vary significantly between the 123 banks subject to the test, andtimely running of the test will be particularly challenging in institutions which are complex due to highly independent business streams, significant geographical reach, or poor integrations of systems and processes from legacy acquisitions.

Some institutions clearly need to raise their game. Stress testing data, and risk data more broadly, is central to proper governance and management of the bank. All banks must ensure that they have a fast, accurate, and robust process for calculating, aggregating and reporting risk data – not just to strengthen the EBA stress tests, but to improve their own internal stress testing and risk management.

The regulators also have a key part to play

Damon Batten
Damon Batten

Without doubt, the regulators also have a key part to play in enhancing the usefulness and timeliness of the stress testing exercises. It is clear that such exercises has value to both investors and regulators, so the frequency should be increased – to at least mirror the annual cycle followed in the US, and even more frequently when possible. Furthermore, the timeframe for the completion of the process should be gradually shortened, challenging the banks to continuously improve, to the point where results can be generated in weeks rather than months.

Naturally, a large part of the rationale for the completion of the stress testing exercise is to reassure the market of the European banks stability. However, it seems that another key source of delay in the process may be the regulators desire to manage the message arising from the results. Of course, good message management is important, but this component of the exercise should also be minimised to the greatest degree possible – and certainly should not overly delay the publication of preliminary results.

Finally, from the perspective of the regulators, there is a need to maintain pressure on the banks to ensure they are making the improvements to their systems and processes which will allow for timely reporting. Given the importance placed on the results by the market, there should be appropriate sanctions available for those banks who submit late or inaccurate results.

The Basel Committee has shown the way forward

Inevitably there will be some who will counter that the complexity of the stress testing process will prevent a move to a shorter cycle for reporting. On the contrary, producing robust, timely stress testing should be a core competency of the banks, and timely review and interpretation a core competency of the regulators – leaving little excuse for the current delays.

Luckily, a great deal of thinking on how risk aggregation and reporting can be improved in the banking industry has already been set in motion – in January 2013 the Basel Committee on Banking Standards (BCBS) published the ‘Principles for effective risk data aggregation and reporting’ (known colloquially as BCBS 239). The document sets out fourteen principles, spanning governance, risk, technology and reporting, which, if implemented in full by the banks, would greatly benefit future stress testing exercises.

The challenge for the banks now is fully to embed the BCBS principles into their risk reporting and governance. In many cases this will require a full review of their reporting technology, processes and procedures – from the input data all the way through to the final reports. Only by completing such an exercise, and committing to maintaining good practice, can manual processes and inefficiencies be minimised, and timely and accurate data be assured.

The regulators have a linked challenge, ensuring that the banks they supervise incorporate the principles into their thinking, and achieve full compliance. Key to this will be making senior management and data owner’s accountable, ensuring governance frameworks and technology are fit for purpose, and that sanctions for laggards have real teeth.

Once this has been achieved, perhaps investors in the EU will have stress testing results they can truly rely on.

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