1. Banking sector stress tests in the EU*
Reiner Martin
Deputy Head of Division
Macro-Financial Linkages
European Central Bank
Banking sector stress tests in the EU*
*The views presented in this paper are exclusively those of the authors and not necessarily those of the ECB.
Mendel University Brno
16 October 2015

2. Outline Introduction and terminology
ECB-confidential
Outline
Introduction and terminology
Banking sector stress tests at the ECB/SSM
The ECB top-down stress testing framework
The Comprehensive Assessment 2014
Outlook
Bank solvency and early warning analysis

3. (Constrained) Bottom-up vs. Top-down Solvency vs. Liquidity
Introduction and terminology
ECB-RESTRICTED
DRAFT
Banking sector stress tests gained significantly in importance since the start of the financial crisis in 2007/08
On-going debates / discussions with(in) ECB/SSM, EBA, NCAs/NCBs, IMF…as well as in the financial sector itself!
Terminology
(Constrained) Bottom-up vs. Top-down
Solvency vs. Liquidity
Contagion / Networks

4. Top-down – for macroprudential purposes
Banking sector stress tests at the ECB / SSM
ECB-RESTRICTED
DRAFT
Top-down – for macroprudential purposes
Quarterly risk impact assessment for the ESRB (EU-wide)
Bi-annual corresponding exercise for the Financial Stability Review (public)
Regular macroprudential impact assessment for the Eurosystem
Top-down for system-wide exercises
(Crisis) country-specific and SSM-wide
Bottom-up – for microprudential purposes
SSM-wide (banks' results for publication)
Input into regular bank-specific supervision (SREP)

5. The ECB top-down stress testing
The ECB’s top-down stress testing framework
The ECB’s top-down stress testing framework
Key features of the model:
Uses granular data of around 130 large SSM banks
Is contingent on a macroeconomic scenario
Accounts for direct impact on banks’ balance sheets
Is complemented with modules to take into account :
Dynamic reaction of banks to macro-prudential policies
Contagion across banks
Macroeconomic models accounting for second round effects on the real economy

6. A. ECB Stress Testing Framework: Overview
ECB-confidential
The ECB top-down stress testing framework
The ECB’s top-down stress testing framework
A. ECB Stress Testing Framework: Overview
Top-down banking sector stress testing framework
Forward-looking solvency analysis
Scenario
Satellite models
Balance sheet
Feedback
Loan loss
models
Funding shock
Credit risk
models
RWA
Contagion
models
Financial shocks
Market risk and securitisation
models
Balance sheet and P&L tool =>
Solvency
Macro
models
Profit
models
Dynamic adjustment
model
Macro
feedback
models
Sources: Henry and Kok (eds.), ECB Occasional Paper 152, October 2013.
Bank solvency and early warning analysis

7. A. ECB Stress Testing Framework: Overview
The ECB top-down stress testing framework
The ECB’s top-down stress testing framework
A. ECB Stress Testing Framework: Overview
Cross-country macro scenario design has to balance various factors:
Adherence to macro-financial story line
Model-based versus expert-based approach to shock-calibration
Model consistency vs. ad hoc assumptions
Need to ensure substantial stress being imposed on all banks in the exercise?
A mixture of model-based and judgemental assumptions
Cross-check: use top-down stress test framework during bottom-up scenario design process to gauge severity
C. Kok - ECB stress testing framework 7

8. The ECB top-down stress testing framework
The ECB’s top-down stress testing framework
Elements of the scenario design
EU macro: “Stress Test Elasticities” (STE)
Multi-country EU-wide shock simulation tool based on impulse response functions (from EU central banks’ models) of endogenous variables to pre-defined exogenous shocks
Allow for country-specific shocks and incorporate EU-wide spillovers (via a trade link block)
CRE prices outside the system and modelled by satellite equations
Non-EU macro: external models (e.g. NIGEM)
A separate toolbox is used to derive pure financial shock scenarios: non-parametric copula approach to simulate joint/multivariate forward distribution of financial variables (model free, can handle large # variables)

9. Satellite models The ECB top-down stress testing framework
ECB-confidential
The ECB top-down stress testing framework
The ECB’s top-down stress testing framework
Satellite models
Credit risk:
Estimation of country aggregate, product-specific model equations
LGD model based on stressed collateral values and LTV ratios (a function of house prices)
Net interest income:
Models for retail interest rates and for wholesale funding costs
Other pre-provision income:
Based on assumptions rooted in EBA methodology
Fee & commission income model (bank panel regression framework)
Market risk and securitisation:
Asset shock calibration (distinguishing between Held for Trading and Available for Sale / portfolios)
Projections of Credit Valuation Adjustments (CVA)
Projection of securitisation book using rating migration matrices
Bank solvency and early warning analysis

10. Overview of solvency calculation
ECB-confidential
The ECB top-down stress testing framework
The ECB’s top-down stress testing framework
Overview of solvency calculation
Definition of capital (country specific)
Input from profit
and loss module
Existing capital
Net operating
income +
Solvency ratio
(minimum threshold) ≤
Risk weighted assets
potential
capital shortfall
Input from RWA module
Bank solvency and early warning analysis

11. The ECB top-down stress testing framework
The ECB’s top-down stress testing framework
Interbank network and contagion models are used to:
Select relevant interbank networks of direct exposures
Static network: can be based on observed networks (e.g. EBA collection, Target 2) or simulated networks (Hałaj & Kok (2013,2015))
Dynamic network: changes in the network take changes in market parameters impacting banks’ counterparty credit risk into account
Simulate default cascades, initiated by banks with shortfalls projected by the BST
Knock-on (domino) effects: default causes other defaults (based on LGD assumptions);
Clearing payment: equilibrium payment after all flows of payments stabilise (endogenous LGD)

12. The ECB top-down stress testing framework
The ECB’s top-down stress testing framework
Macro feedback models
Used to calculate the impact of the changes in bank balance sheets on macroeconomic variables (GDP, investment, consumption, housing, etc.)
Vector autoregressive models (GVAR/VAR): estimate endogenous relationships between real and financial variables including proxies for regulatory/macro-prudential measures, such as capital and liquidity ratios. (Gray, Gross, Paredes and Sydow (2013), Gross (2013), Gross and Kok (2013) )
Dynamic general equilibrium models: derive macroeconomic and financial relationships from microeconomic principles modelling directly the pass-through mechanism of shocks to macroeconomic and financial variables. (Żochowski (2014), Darracq Pariès, Kok and Rodriguez Palenzuela (2011))

13. Key features of the Comprehensive Assessment 2014
3.2 Looking back to the CA ST bit – combination of the 2
The Comprehensive Assessment 2014
ECB-RESTRICTED
DRAFT
Key features of the Comprehensive Assessment 2014
One-off exercise: starting point for and pre-condition to SSM
Next time will be different – now the SSM is there!
Timeline, methodology, templates, publication (largely) in common with EBA
2 Components - an Asset Quality Review and a constrained bottom-up stress test with top-down quality control

14. Reduction in bank capital ratios under the adverse scenario
4.2. CET1 projected to decrease by 4% under the adverse scenario
The Comprehensive Assessment 2014
Location,
Reduction in bank capital ratios under the adverse scenario
SSM median: 4.0%
Name of the Author

15. Breakdown of aggregate impact of ST under the adverse scenario
4.4. Under the adverse, SSM average CET1 declines from 11.8 to 8.8%
The Comprehensive Assessment 2014
Location,
Breakdown of aggregate impact of ST under the adverse scenario
Weighted means; excluding the AQR impact on starting point capital
NB: LLP and NII key drivers to the deviations from baseline CET1.
Name of the Author

16. Capital shortfall by country
4.3. At least one bank with a capital shortfall in 11 of the 19 countries
The Comprehensive Assessment 2014
Capital shortfall by country
Total
shortfall
(€ BN)
2.37
8.72
1.14
9.68
0.07
0.86
0.87
0.54
0.23
0.13
0.03
0.00

17. Top-down vs. Bottom-Up results
The Comprehensive Assessment 2014
5.2. Comparing Bottom-Up and Top-Down results
ECB-RESTRICTED
DRAFT
Top-down vs. Bottom-Up results
Top Down results were generally somewhat more “conservative”
So called ‘Quality Assurance Process’ led to gradual convergence of results over time
Supervisory dialogues meetings bridged the remaining gap at the end of the process
Top-down results helped the QA process and ultimately helped to boost credibility of the SSM banking sector

18. Bank equity prices came closer to those of other firms
The Comprehensive Assessment 2014
5.3. Around the CA – The exercise brought banks closer to other firms
Bank equity prices came closer to those of other firms
Source: Bloomberg

19. Decoupling banks from sovereigns
The Comprehensive Assessment 2014
5.5. Around the CA – Decoupling banks from sovereigns
Decoupling banks from sovereigns
Source: Datastream

20. Other countries follow different approaches, e.g. the US
Outlook
ECB-RESTRICTED
DRAFT
The ECB/EBA banking sector stress test 2016 will again be a constrained bottom-up exercise with top-down-driven QA (but no AQR!)
Other countries follow different approaches, e.g. the US
Stress test ‘construction sites’:
Solvency stress tests
Stress tests for non-bank financial firms (insurers, pension funds, ‘shadow banks’)
Network analysis (within sectors and beyond)

21. ECB-confidential
Annex slides
Bank solvency and early warning analysis

22. Evolution of main balance sheet items
ECB-confidential
The ECB top-down stress testing framework
The ECB’s top-down stress testing framework
Overview of P&L calculation
Balance
sheet
Net interest
income
Loan loss
calculation
Market
risk
Profit and loss
calculation
Net interest income
+ Net fee and commission
+ Net trading income
– Staff expenses
– Depreciation and amortization
– Administrative expenses
– Other net operating income
= OPERATING PROFIT/LOSS
– Provisions on loans and advances
– Other provisions (e.g. financial assets, goodwill)
= PROFIT/LOSS BEFORE TAXES
– Taxes
– Minority interest
= NET INCOME/LOSS
Evolution of main balance sheet items
Interest
Income
and
expenses
calculation
Loan loss
and
impairment
calculation
Trading
income
Foregone interest
income on NPL
Balance
sheet
assump-
tions
Input from
interest rate
models
Input from
loan loss
models
Input from
various
models
Input for other
income/expense
components
Bank solvency and early warning analysis