Stress Testing Disclosures in Europe

It’s an interesting question. I believe the approach was much more pragmatic in the US, meaningful goals were established and communicated, and outcomes were outlined. Most importantly, a financial backstop was put in place to assist any banks that failed the tests and to support restructuring and recapitalisation. The Fed has also focused on the quality of data underpinning the banks’ stress testing and has been running their own models and comparing the results with those of the banks.

The market understood the need to reduce systemic risk and market participants were pleased with the results, despite the fact that some real capital adequacy issues came to light. In the end, banks raised $75 billion of new capital, and systemic risk was significantly reduced.

In Europe, the goal was similar but the complexity of having so many countries and regulators working together, all whilst doing the exercise for the first time during the sovereign crisis, made the process more difficult. Ultimately, the exercise failed to reassure the markets. In the end, with no backstop and a lack of clear objectives, the disclosures created confusion and the desired result was not achieved.

The ‘when’ question is important. In times of crisis, reassuring the markets is critical. In order to do that, banks need to not only provide information that adds value, but also need to be seen as addressing the issues that market participants view as vital and relevant. Communicating a clear message and providing scenarios can be relatively painful for banks. However, it is important to be explicit and realistic, whilst tackling issues head on. In times of financial stability, providing aggregated results is often sufficient to confirm market expectations. Now that banks are required to be more explicit in their disclosures, the results should be sufficient to confirm market expectations.

It is interesting to observe this impact. So far, regulatory pressure has forced banks to develop a stress testing framework, particularly because banks want to simulate pre-regulatory exercises and the impact of adverse scenarios on their regulatory capital ratio. We have observed this trend in discussions with banks and confirmed it through the various surveys Moody’s Analytics conducted in the US and Europe.

Right now, banks understand that in order to restore their reputations they need to disclose more information. The role of the Enhanced Disclosure Task Force, sponsored by the FSB (Financial Stability Board), is to help establish some form of industry reporting best practices to help ensure this disclosure occurs. The group is unique in its variety of market participants – rating agencies, banks, investors, analysts – and together they will define what the banks should be disclosing, preferably in a standardised form. We have been advising our bank clients to closely follow the Task Force’s progress and published documents.

The approach is still flexible. Moody’s Analytics has discussed the recommendations with some of the group’s members and they are keen to implement the recommendations rapidly, particularly the large banks. At the same time, members want to reassure and stabilise the markets by disclosing relevant and appropriate information, whilst maintaining a level playing field and reducing volatility by avoiding the over-disclosure of sensitive information. This outcome would help banks not only understand the expectations of market participants, but also focus on key business elements that should be addressed to disclose the necessary transparent and granular information.

The main change is that the European Central Bank (ECB) will take on the role of a single supervisory mechanism (SSM), which is critical in ensuring that any kind of stress testing in the future will be done on reliable balance sheets. The ECB will evaluate the real value of assets and liabilities of all these banks, which is no easy task. What is crucial now in Europe is for the banks to not fail the tests in coming months under the new supervisory regime of the ECB.

It makes sense for the EBA to wait until the SSM is in place, after the evaluation has been done. This would give banks the opportunity to clean up and raise capital before the ECB takes on its new role. It is expected that the ECB will take a strong stance in control and supervision afterwards. This may be difficult to implement but is expected to occur.

It seems that we are headed toward a US-type of framework in Europe. In the UK, the Bank of England (BoE) and the Prudential Regulation Authority (PRA) are planning on developing a new recurrent stress testing of the UK banking system, similar to CCAR in the US. The Spanish regulator seems to be inclined to follow a similar approach. Finally, banks will probably lose part of the benefits of having been supervised by their local central bank, so they may expect a tougher stance and stricter application of the regulation.

Going back to the first question, regarding the comparison between Europe and the US, in my opinion European banks should and could learn a lot from the US. For example, looking at the evolution that took place between the SCAP in 2009 and CCAR sessions up to a few months ago, it is evident that the regulators are using disclosure to orient the market toward their desired outcome, which is greater stability. It is a painful yet necessary exercise.

In terms of lessons learned, I believe in going back to basics. Without providing clear direction, surprises may occur. This is exactly what has happened in Europe twice already. In 2011, Europe tried to compensate a poorly designed and perceived stress testing exercise by providing too many exposures and information with more than 3000 data points.

This exercise was upsetting for many banks. Although it was used in some cases by analysts to better understand banks’ exposures, the volume of information was too high for market participants to use unless they had anticipated that volume of disclosure and had the tools to process it rapidly. Another factor is the need to perform due diligence based on that detailed information. Not all banks had the capabilities to perform the due diligence or use the information to make more informed decisions.

As for the benefit of disclosure, several academic analyses have been done, based on cumulative abnormal returns, to evaluate the potential impact of the stress tests on banks. It shows that stress test disclosures do add value by reassuring market participants and do raise the value of the banks as it increases returns abnormally, compared to a non-stressed peer group. The benefits cannot be ignored.

In Europe, the complexity of having so many countries trying to cope with the tests at the same time, with the same scenarios, made it very difficult for banks and local regulators. The transformation of the supervisory regime from local regulators controlling their own banks to the wider organisation, the EBA, and soon the ECB, created a lot of frustration. Banks were frustrated not only because the stress testing framework kept evolving whilst banks where trying to produce results, but also because it was difficult to obtain needed clarifications in due time.

Learning from that experience, banks must have the tools and processes that will allow them to adapt seamlessly and follow a moving data and reporting framework. Once again, if the European Banks will have to follow a stress testing pattern similar to what CCAR has imposed on Banks in the US, it is probable that banks will have to gather a massive amount of detailed information to support required simulations and also to feed a central data repository to be used by supervisors to manage financial stability. It is also clear that the CCAR framework is not a set approach but an evolving exercise following market conditions and supervisory trends.

Such an approach is apparently already happening in some countries, like in the UK with the PRA Firm Data Submission Framework (FDSF) for the Systemically Important Financial Institutions (SIFIs).

In my opinion, the US regulatory reform is a good example of what may happen in Europe. In the US, if a bank fails to pass a stress test, the impact is measured in many areas, such as capital management, business strategy, share buybacks, or compensation. Even the possibility of this outcome motivates shareholders and management to ensure that the tests are done accurately and effectively. I expect that in Europe, banks will follow a similar track.