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    ESRB Paper Presents Alternative Approach to EBA Stress Test Proposal

    August 05, 2020

    The Advisory Scientific Committee of ESRB published a response, in the form of an Insights Paper, to the EBA proposals for reforms to the stress testing framework in EU. In the paper, the authors assert that the EBA proposal is a significant step backward in terms of transparency, reliability, and comparability of the results. This is because of the envisaged ample leeway for supervisors, limited disclosure in the supervisory leg, and the greater flexibility and reduced quality assurance in the bank leg. The paper presents a sequential approach in which an enhanced single-leg, bottom-up stress-testing exercise run by EBA is regarded as the primary source of granular, reliable, and comparable information for subsequent supervisory applications.

    EBA launched the consultation on the proposed stress testing framework in January, with the consultation scheduled to end on June 30, 2020. In addition to several methodological innovations, including the consideration of multiple adverse scenarios or the relaxation of the static balance sheet assumption, the main proposals in the discussion paper refer to restating the purpose of the EBA stress test as a primarily micro-prudential exercise and replacing the current design in which banks and (micro-prudential) supervisors share ownership of the results (as the two parties iterate before arriving at the supervisory-validated results) with a two-leg design. In the supervisory leg, supervisors would have greater discretion to introduce bank-specific adjustments and would publish a more limited range of results than under the current design, with the main objective being the estimation of the capital deficits necessary for calibrating their Pillar 2 Guidance requirements. In the bank leg, individual banks would have greater flexibility in the use of their own methods and data to produce results that would cover a similar range of granular information as under the current framework, but they would be subject to less intense quality assurance by their supervisors.

    This paper expresses serious concerns about these two main proposals. First, the EU-wide stress tests are a big endeavor for banks and supervisors. Redefining their objective as primarily micro-prudential would unnecessarily narrow down their scope, condition their future development, and potentially induce some duplication of information gathering costs to satisfy macro-prudential authorities’ needs that might no longer be met properly. Second, the two proposed legs could give rise to more abundant but less reliable and comparable—that is, less useful—information. This could occur if the supervisory leg turned out to be more opaque and were to disseminate less granular results than the current framework, while the greater flexibility and reduced quality assurance in the bank leg would decrease the comparability of the results across banks and increase the margin for misrepresentation. The paper discusses the alternatives to the two-leg design that are more compatible with the dual micro-prudential and macro-prudential use of the information gathered via the stress tests.

    The paper advocates an alternative to the two-leg approach, which separates bank-originated calculations from supervisor-originated calculations at an early stage. This would be a sequential approach in which an enhanced single-leg bottom-up stress-testing exercise run by EBA is regarded as the primary source of granular, reliable, and comparable information for subsequent supervisory applications. Under this approach, the enhanced EBA exercise would come first and end with the publication of aggregate and individual results for the supervised entities. The corresponding micro- and/or macro-prudential supervisors would come next; they would introduce adjustments and elaborations in line with their own objectives before publishing the adjusted or elaborated results that would determine their regulatory requirements and policies. The suggested sequential approach would not involve an unnecessary redefinition of the EBA stress-testing exercise as primarily micro-prudential and would allow both micro-prudential and macro-prudential authorities to leverage the output of the stress test (stages 1 and 2 of the sequential approach), without preventing them from adjusting and elaborating on the data obtained (stage 3). To strengthen the common European perspective and minimize the risk of undue weight being given to national considerations, a significant increase in the financial and human resources that EBA can devote to stress-testing exercises will also be required under this alternative approach.

     

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    Keywords: Europe, EU, Banking, Stress Testing, EU Wide Stress Test, Pillar 2 Guidance, Top-Down Stress Test, Bottom-Up Stress Test, Basel, EBA, ESRB

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