European Parliament Issues Paper Examining the 2018 Stress Test Design

The major change compared to the 2016 exercise is that the 2018 exercise incorporates, for the first time, the IFRS 9 accounting standards, which contributes to the increased severity of the exercise. Accordingly, banks are requested to account for credit impairments associated with their riskier loans not only over a twelve-month period, but also in a lifetime horizon. The stress testing methodology also incorporates several measures to guarantee internal consistency. However, despite all the progress made in designing the exercise, there remain critical areas such as the application of a static-balance-sheet assumption, the under representation of liquidity risk, and the implications of the lack of a fail-pass threshold. The paper suggests that improvements in these areas can enhance reliability of stress test results and empower their role as external and internal communication tools.

EBA, in 2018, has required 48 significant banks covering roughly 70% of the banking sector assets in EU to perform a stress test to assess their resilience during 2018–2020. The exercise is based on a common methodology and a set of templates that capture starting point data (year-end 2017 figures) and stress test results. The results will be published on November 02, 2018. As in the 2016 exercise, there is no pass-fail threshold, but results will be input to the supervisory review and evaluation (SREP) process, under which decisions are made on appropriate capital resources and forward-looking capital plans. Similar to the 2016 exercise, the 2018 EU-wide stress test is based on common methodology and a “constrained bottom-up” approach,that is, banks make their projections but are subject to strict constraints and simplifying assumptions.

Related Link: Research Paper (PDF)

Keywords: Europe, EU, Banking, Stress Testing, 2018 EU Stress Testing, ECL, IFRS 9, European Parliament, EBA