EU-Wide stress test: Tougher than in previous years

On January 31st, the European Banking Authority (EBA) announced the formal launch of this year's EU-wide stress test exercise of the euro area. It also unveiled the macroeconomic scenarios under which the exercise will be carried out. The adverse scenario implies a deviation of EU GDP from its baseline level by 8.3% in 2020, resulting in the most severe scenario to date. The EBA expects to publish the results of the exercise by 2 November 2018

Stress tests are intended to assess the resilience of EU banks to different macroeconomic situations. After the international financial crisis of 2007, they have become a relevant supervisory tool.

This year's stress test will be the sixth conducted by the European Banking Authority after the ones carried out in 2009, 2010, 2011, 2014 and 2016. Results will be published on November 2. For the first time, the test incorporates the impact of the new IFRS 9 accounting standards. Just as in 2014, no pass-fail threshold has been included as the results of the exercise are designed to serve as an input to the Supervisory Review and Evaluation Process (SREP), that the ECB requires institutions to undergo from time to time to determine the amount of capital that they are required to hold.

The test will be conducted on a sample of 49 banks, all of them with assets in excess of €30 billion. This equates to analyzing 70% of total banking sector assets in the EU. The sample includes five Spanish banks: BBVA, Santander, Caixabank, Sabadell and BFA (Bankia's holding).

Macro scenarios

The European Banking Authority has announced the macroeconomic scenarios based on which the test will be carried out. The baseline scenario is in line with the growth forecasts published in December by the European Central Bank. The adverse scenario is designed to ensure an adequate level of severity in all EU countries. The implicit EU real GDP growth rates under this scenario would be -1.2%. -2.2% and + 0.7% in 2018, 2019 and 2020, respectively. Overall, the scenario implies a deviation of EU GDP from its baseline level by 8.3% in 2020. This is the most severe stress test scenario to date for the euro area.

This adverse scenario assumes the materialization of four systemic risks that currently represent the most material threats to the stability of the EU financial sector. These risks are:

• Abrupt and sizeable repricing of risk premia in global financial markets -triggered e.g. by a policy expectation shock -leading to a tightening of financial conditions.
• Low nominal growth rates, due to the decline in economic activity within the European Union. This would particularly affect banking sectors still facing the resolution of structural challenges.
• Uncertainty regarding public and private debt sustainability amid a potential repricing of risk premia and increased political fragmentation.
• Liquidity risks in the non-bank financial sector with potential spillovers to the broader financial system.