Stress testing; challenges between economic growth, banking stability and the implementation of improved regulation.
Up to 2007, banks and other financial institutions were considered safe havens by investors and the public. Before the global financial crisis, banks failed, went bankrupt or were auctioned occasionally. These incidents were often triggered by unconventional events.
The failure of Northern Rock in the United Kingdom, Landsbanki in Iceland and Lehman Brothers in the United States revealed an extensive interconnectedness between financial institutions, both global as well as domestic. Governments had to improve their deposit guarantee schemes and European directives guided member states to the implementation of an equal safety net for bank depositors.
It is noteworthy that all banks mentioned had a substantial exposure to real estate value and mortgages, and were dependent on a similar funding mechanism for its loan portfolio. While most US based financial institutions were compliant with the capital requirements under the Basel II framework (History of, 2016), a prolonged and global financial crisis started.
One can argue that the Basel guidelines urge market players to find maximum profitability within the regulatory framework (The Regulatory Responses, 2014). The extreme growth of usage of derived products like synthetic CDO’s, is an example of such behaviour.
Assumed excessive risk taking, the moral hazard and potential bail outs with tax payer funds, enforced a negative public opinion towards financial institutions. Populism and occupy movements gave the people a voice. At the same time, we cannot ignore the current technical revolution, the rapid expansion of Fintech based firms, and, from a complete different perspective, new political insights.
The profound impact the crisis and the current fast-changing economy has on society calls for action. Regulators need to implement new rules that prevent similar events from happening. A wide range of measures need to avoid a next crisis, while simultaneously economic stability must be safeguarded. A potential conflict of interest, since economic growth is stimulated by consumer confidence that leads to spending.
The Basel II accord exposed a different challenge; market discipline is not just measured by a ratio. It relies on self-management and the moral obligation to protect customers and the financial institution itself. The global financial crisis clearly showed that incentives and bonusses are a motive for excessive risk taking and that the framework encouraged the usage of off balance sheet solutions.
A paradigm shift is needed. Truthful information must be used to predict future scenarios that provide input for the Supervisory Review and Evaluation Process. This evaluation allows regulators to take relevant action. Stress testing is one of the ways to see how individual financial institutions react to different specific negative scenarios happening at the same time.
Business models used by financial institutions before the global financial crisis (The role of, 2009) relied on fractional reserve lending and securitization. Uncontrollable economic growth and excessive risk taking resulted in a hard reset of the financial markets. Macroprudential regulation was improved or sharpened and new requirements were implemented.
Rose and Spiegel (2011) acknowledge that predicting the beginning of a financial crisis is difficult. Therefore, the regulatory framework should encourage financial institutions to take effective measures that protect the capital position against rigorous losses. Regulators need input to create such regulatory framework. This input can be retrieved for example from macroprudential stress tests that assume specific negative systemic events.
The Basel Committee on Banking Supervision (BCBS) aims to close gaps in international supervisory coverage and eventually create economic stability. The committee released several accords named Basel I, II and III to calculate, define and improve the banks regulatory capital. Tier 1 capital as defined in the Basel accords, is also part of stress testing where an adequate level of core capital is required to protect individual banks against heavy losses, possible systemic rest and evidently ‘pass’ the test.
Systemic risk and contagion in the financial industry are worse case scenarios for regulators. To avoid crises and government intervention with tax payer money, financial institutions must follow strict rules. Since market conditions and the economic landscape are subject to change, regulation must be adjusted and improved periodically.
The European Banking Authority (EBA) developed a model to analyse the impact specific negative future events can have on the capital position of individual banks. The model distinguishes between a baseline and an adverse, systemic scenario. Since the model is based on assumptions it doesn’t always reflect true market risk. Another difficulty is to simulate a future scenario. The test compares ‘before the fact’ reality with ‘after the fact’ measures (Bessis, 2010).
Testing results provide information for regulators to determine future actions that safeguard financial stability. Stress test results identify potential weaknesses and focus on capital. Although scenarios like a market crash, decline in property value, the sudden change in the oil price and other important economical fluctuations are often triggered by non-financial events, the deriving transparency is an important driver for consumer confidence. The bank’s tier 1 capital must be sufficient to remain solvent after the designated and tested event takes place. Although the most recent stress test did not provide a pass or fail rating, published results might trigger unintentional market responses.
The testing environment exposes results derived from external, and a form of internal impact. This internal impact may include credit risk, market risk and other profit components, where the external impact refers to a macroeconomic scenario (Constancio, 2015).
Global differences in stress testing make it difficult to create balanced output. The EBA, Bank of England (The Bank of, 2015) and the Federal Reserve in the USA all use different scenarios to achieve test results. Globalisation and the significant impact that Systemically important financial institutions (SIFI) have on the world economy, could justify the usage of an identical worldwide stress test tool.
The most recent EU-wide stress test took place in 2016. The adverse scenario covered a period of three years and included variables such as GDP, inflation, unemployment, asset prices and interest rates in relation to profitability and bank capital (Adverse macro-financial, 2016). Main risk types used in the stress test include credit risk and securitisation, market risk, sovereign risk, funding risk and operational and conduct risk.
Stability of the financial sector is the key element in a stress test. The European Systemic Risk Board (ESRB) indicates four systemic risks as part of the stress test. Macro financial impacts determine the outcome of the adverse scenario for the EU-wide stress test. Designated risks in low nominal growth environments include: (i) Sudden reversal of compressed global risk; (ii) Weak future profitability for financial institutions; (iii) Increase of debt sustainability concerns; and (iv) Prospective stress in a rapidly growing shadow banking sector, amplified by spill over and liquidity risk.
The real weakness of European banks
Although test results initially stayed confidential, input and output of the recent European stress test invite the public to respond. The results of the test support consumer confidence, however this conclusion is biased. Only 51 banks, that covered up to 70% of the market share in the European banking sector (Frequently asked, 2016), were tested. The weakest countries and smallest banks were left out. It is remarkable that realistic events, such as long term negative interest rates and sovereign debt were not part of the test.
One can understand the current vision of regulators. Economic growth is slow and low interest rates don’t have the anticipated supportive effects. Failure of a stress test could have an impact on the economy and even trigger a bank run, which is the opposite of what regulators eventually want to achieve with the test results. Consolidation is required to eventually build a system where tier 1 capital or even external capital buffers can create a safety net for unexpected crises.
We can conclude that the current stress test model is sufficient to determine specific risk in median financial institutions. Firms that operate outside the scope of this median group, for example because they hold an excessive portfolio of non-performing loans, qualify as a global systemically financial important institution, because they act in highly specialised and risky niche markets, or even due to their geographic location in a country that is trying to reconstruct its economy and internal policies, should get a different stress test that perhaps include immediate measures and even a temporary alternative resolution decree until the financial institution is healthy again.
Criticasters like Larry Elliott (The EBA’s, 2016) argue that a potential default of Greece and the possibility of countries leaving the Eurozone should be included in testing exercises as well. Daniele Nouy, head of the supervisory board of the European Central Bank, sees challenges for banks in relation to profitability of the business model and nonperforming loan portfolios.
Historical events and financial crises provide data that help us understand the overall triggers of financial distress. The shortage of loss absorbing capital is a consequence of the failure of the current regulatory system to close the gap between creative solutions from the market participants to find loopholes and work at the edge.
Innovative off balance sheet products and accounting tricks as the Repo 105 used by Lehman Brothers, concealed the fragility of many banks in the pre-stage of the global financial crisis. The availability of easy lending against little or even worthless collateral combined, and poor debt management is one of the reasons many banks are struggling to comply with a stricter stress test.
Business models and profitability in the financial industry are under pressure. Efficiency and stability becomes more important, while the implementation of the new Basel framework creates better capital buffers, and improves the quality of the loan portfolios. The counter effect of this new regulation is that the economy could further slow down due to the decrease of funds channelled into the real economy via loans to the public.
Another example that such behaviour takes place on all levels is the governments that try to diversify their income streams. Countries like Malta and Cyprus offer citizenship by investment programs. Investors need to buy property, invest in the local economy or deposit substantial fixed deposits at local banks to get citizenship or even a passport. These short-term solutions create another bubble in the real estate market and local economy and are not sustainable.
An alternative government project is the e-residence program offered by Estonia. The program acts as a gateway to the local market where e-residents incorporate Estonian companies, open local bank accounts and appoint accountants. Steady and sustainable economic growth is a long-term process when it relies on one pillar. Diversity is the answer, not only for governments, but even more for financial institutions.
Recapitalization of financial institutions while the back door is wide open, cannot solve the challenges banks currently face. The real weakness of European banks is not just a shortage of capital, it is a combination of moral hazard, limited regulation, potential to play the system and profitability that need to be solved while at the same time tier 1 capital must improve.
Loan portfolio risk in an era of financial stress
Bad debt is considered one of the reasons for low profitability of European banks (Constancio, 2017). The lack of interest payment on defaulted loans lowers profitability and decreases the possibility to provide new loans. When payment terms are not met, the lender must reserve capital to write the loan off against minimal losses.
Before we can determine the effect, non-performing loans (NPL) have on the stability of financial institutions, it is worth to mention some reasons for default on debt. A non-performing loan qualifies as such when over a period of 90 days the agreed repayment arrangement is not honoured. Since economies are dependent on banks offering credit, the NPL issue is a serious concern.
An excessive growth in NPL was commenced during the global financial crisis. Economic growth stimulated property prices to unfounded but exorbitant heights. Funding and securitization of bundled loan packages resulted in excessive risk taking by lenders.
Imbalance between a loan and its collateral makes debt recovery after default difficult. The client must repay the difference between the current value and the size of the loan and when he is not able to do so, some countries offer an escape route in the form of personal bankruptcy or voluntary debt restructuring, leaving the lender with a loss on interest income and redemption on the total outstanding loan.
During recent years, lenders, consumers and SMEs (small and medium-sized enterprises) took more risk and morality to repay loans after default changed (Bruegel, 2017). The regulatory framework allowed such and the descending economic climate increased unemployment. Unemployment and the lack of sufficient savings cause a situation where default on credit gets realistic.
An effective way to handle bad debt arises when the diligent inflow of new loans get stricter while simultaneously NPL portfolios are placed in Asset Management Companies (AMC), also known as ‘bad banks’. Regulators must be aware that an AMC doesn’t create a similar situation as seen with securitization of synthetic collateralized debt obligations.
In Spain, NPL’s were concentrated in the real estate sector (Bruegel, 2016). The Spanish NPL reduction process is stable and collaborates with comprehensive financial sector restructuring and recapitalisation, and is an example for other European countries. Sweden is another country that manages the resolution of NPLs quite well. At the same time profitability and lending to the real economy is growing.
Banks can take several measures to cope with their NPL challenges. New applications and loan provisioning should follow strict debt management procedures where collateral and repayment is safeguarded. Additional insurance that covers the loan, could create the needed security. On the side of the NPL portfolio, a specialized recovery procedure under external management can be founded. Recovery programs are already operational at numerous banks and the most successful programs can be copied.
A legal framework for early restructuring of private debt is not always available (Prudential treatment of, 2016), there are however numerous leads for operational efficient debt restructuring programs. In the Netherlands for example, banks have ‘special debt management’ business units and the law foresees in private debt restructuring during an ‘out-of-court’ and regular personal bankruptcy procedure.
The scenario used by the EBU stress test in 2016 assumes a reasonable recession. It is comprehensible that most of the tested banks passed this test.
Clarity is needed to help stakeholders understand the aim of a stress test. Even banks like German based Helaba and Pastor from Spain had reasons to distrust the results of the stress test. For Helaba, silent holdings of the German government were disregarded in core tier 1 capital calculation. Banks in Spain are required to create additional reserves in times of economic prosperity to have a buffer for economic downturn.
Additionally, the global financial crisis revealed that market participants always try to find loopholes and creative ways to ‘play the system’. Clarity and a stricter testing environment could be the answer to the input of the testing subjects.
The Basel III accord wants banks to improve their Tier 1 Capital ratio (Basel III definition, 2011) and eventually avoid bank failures. Both the Basel Accords as well as stress testing focus on capital enhancement by attracting new capital. Not only does this approach improve the core capital position of banks, it also creates a potential new internal risk management framework that reduces default risk for the loan book.
Efficiency in the business model, like reducing the workforce, and, for example automation or outsourcing to Fintech firms get no attention from regulators. Rapid technological changes put pressure on the profitability of banks, therefore a stress test could award banks who take proactive measures and work on stability, profitability and flexibility.
Another suggestion can be to take apart stress test participants based on their profile. A tailor- made testing environment provides regulators with effective input for future regulation. Also, countries like Greece and Portugal can be part of this additional stress test to avoid biased results.
International differences in stress tests make it difficult to define a global risk profile. An international streamlined process, for example by running the stress test for European banks based on the different models of CCAR, the Bank of England and the EBU to test banks stability, offers regulators input from different perspectives.
Consolidation of the international banking system is needed to enhance the sectors profitability. Mergers can help to achieve this profitability. However, regulators must be careful not to encourage collaboration resulting in global systemically financial institutions, organisations considered to be too big to fail.
Since lending is the backbone of the European economy, lending criteria and charges should be part of a stress test. Both a raise the interest rate as well as a long term negative rate should be included in every test. Also, radical changes in the economic environment, such as countries like the UK leaving the Eurozone, are realistic and therefore the effects of such an event should be included in the test.
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