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    ECB Paper on Macro-Prudential Stress Test of Euro Area Banking System

    July 02, 2019

    ECB published a paper that presents an approach to a macro-prudential stress test for the euro area banking system, comprising the 91 largest euro area credit institutions across 19 countries. The approach involves modeling banks’ reactions to changing economic conditions. It also examines the effects of adverse scenarios on economies and the financial system as a whole by acknowledging a broad set of interactions and interdependencies between banks, other market participants, and the real economy. The results highlight the importance of the starting level of bank capital, bank asset quality, and bank adjustments for the propagation of shocks to the financial sector and real economy.

    The paper presents stress test results in the baseline scenario and lays out the main results for the adverse scenario. All the summarized results are based on banks’ reactions to the original adverse scenario included in the 2018 EU-wide stress testing exercise. Next, the paper elaborates on selected aspects of the adverse and baseline scenarios along with the macro-prudential perspective. It also introduces estimates of the effect of triggering the second-round effects on output and the real economy more broadly. Finally, the paper discusses the potential role of non-banks in the transmission of the adverse scenario. 

    The report evaluates performance of the euro area banking sector in 2018-20 under the scenarios of the 2018 EBA supervisory stress test. The results complement the findings of the supervisory stress test. Compared with the results derived under the constant balance sheet assumption, banks’ system-wide capital depletion in the adverse scenario is higher in the macro-prudential stress test. When comparing adverse system-wide common equity tier 1 (CET1) capital levels in 2020 against the end of 2017, the macro-prudential stress test reveals a EUR 35 billion higher capital depletion then the analogous constant balance sheet exercise for the same sample of banks. However, because of banks’ deleveraging, CET1 ratios are on average higher in the macro-prudential stress test. Compared with the 2018 Financial Sector Assessment Program (FSAP) stress test results, the timing of the impact on bank solvency differs. FSAP foresees a gradual impact of the adverse scenario on banks’ capital, in contrast to the more front-loaded impact in the macro-prudential stress test. The prediction of relatively lower capital ratios by the FSAP is mainly driven by higher severity for certain high-spread economies and by the less pronounced deleveraging of banks facing strained capital levels.

    Banks experiencing a CET1 capital shortfall compared with their capital requirement decrease their lending to a relatively greater degree than do banks with a CET1 surplus. Accordingly, loan growth of a large share of banks in the adverse scenario is negative, especially in the case of non-financial corporations. Interbank contagion may advance the deterioration of banks’ capital shortfalls. A contagion mechanism related to the direct interconnectedness between banks could lead to an additional CET1 ratio depletion amounting to 75 basis points by the end of 2020. This estimate involves both solvency and liquidity distress and assumes a default on bilateral exposures and short-term funding withdrawal by those banks experiencing capital shortfalls. The paper also evaluates the effect of adding the feedback loops between the financial and real sectors, in addition to the interactions between banks and other counterparties in financial and capital markets.

     

    Related Link: ECB Paper (PDF)

     

    Keywords: Europe, EU, Banking, Stress Testing, CET 1, FSAP, Macro-Prudential Policy, Adverse Scenario, Baseline Scenario, EBA, ECB

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