The European Banking Authority (EBA) started the new decade with its new vision for the future of stress testing.
In the innocuously titled “EBA/DP/2020/01”, the EBA outlines its proposed changes that are rather more substantial than what meets the eye. At its core, the regulator is aiming to address the inevitable trade-off between comparability and relevance of the results. Achieving comparability between banks requires tighter methodology constraints whereas increasing relevance hinges on reflecting the idiosyncratic nature of individual institutions’ risk profile and response options when under stress.
The EBA proposes to seek an optimal balance between comparability and relevance via the double reporting of results, separately by the EBA and the participating Bank.
Allowing a public divergence between bank and regulatory views on resilience under stress puts the ball firmly in the bank’s court. While the EBA will continue to use a prescribed methodology to derive the supervisory view, banks are free to either concur with the EBAs prescriptions, modify them, or even discard them altogether. However, the EBA will be publishing both views at a granular level – with the onus on banks to explain any divergence between their internal view and the view of the EBA. In addition, the EBA will no longer Quality Assure banks’ submissions. Instead, banks will have to take full ownership and responsibility for the results – alongside any risk insights market participants would derive from them.
The proposed changes should help to promote a “best of both worlds” outcome for banks, large and small. Smaller firms with less developed stress testing capabilities can agree to the supervisory approach and reduce the internal regulatory burden. However, larger firms can choose to diverge from the methodology constraints and present a management view of the post-mitigation impact of stress. A detailed proposal for methodology override is not yet formulated, however the material changes that are known today include the removal of static balance sheet constraints, allowance of managerial actions confirmed post stress test start date and giving banks more freedom in forecasting risk drivers.
Another change the EBA is proposing is to increase the number of scenarios aimed at assessing banks’ resilience point-in-time, when compared to previous exercises. This brings the EU-wide stress test closer to the ‘dynamic’ approach utilised by the US Federal Reserve. Potentially the most material proposal is the introduction of ‘exploratory scenarios’ which are focused on short-term shocks (e.g. a liquidity shock), or long term non-financial risks (e.g. climate change).
The implications for banks are material. As they become responsible for both the stress testing results and the explanation of any divergence from the regulatory view, they will increasingly need to quantify the impact of management actions from “bottom-up”. When considered alongside the requirement to complete other local regulatory exercises and internally commissioned scenarios, all of which may have different constraints, banks will need to adopt a much more flexible, analytical infrastructure. A shift of the Stress Testing paradigm from an approach based on dispersed models and manual processes to one supported by a consistent IT environment designed with the flexibility to support multiple configurations seems inevitable.
With the new framework due to be rolled out in 2022, banks have a limited window to lay down the foundation for future success. As a starting point, banks must improve their internal data quality to enable more effective use of modern technology to meet the regulators new proposals. This lies at the core of making stress testing a truly meaningful exercise, regardless of the evolution of regulatory proposals.
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