Stress testing of banks and policy implications

By: Piroska M. Nagy, Senior Adviser to the Chief Economist

Recent stress tests, while admittedly not perfect, have proven useful to bring a degree of clarity over banks’ portfolio quality. When backed by credible financing plans, the tests have helped confidence in battered banking sectors. In Europe two major regional exercises are under way: a CEBS-coordinated and nationally-implemented testing of the largest EU-based bank groups, and a regional exercise by the IMF, both with expected results around September.

Peer pressure, positive market reaction to previous stress tests, and risks of leaks in the European multi-player setting can argue for publishing the results of the CEBS stress tests in some form, and back them up financing plans. These can include raising capital from markets and use of unutilized national bank support packages (raising the issue of burden sharing between home and host authorities); at the margin, IFI/EBRD equity support for bank subsidiaries in the region can also help. Careful use of new EU competition policy to avoid abrupt deleveraging will be very important. Coordination with the IMF with regards to both the results and their communication would be also necessary.

Background Central banks and regulators increasingly use stress testing to assess the quality of their banks’ portfolios in the wake of the ongoing financial crisis. This is used to determine the amount of any additional capital that banks may need so as to reach an acceptable level of capitalisation in the face of shocks.   In the face of persistent uncertainty about bank portfolio quality, markets have learnt to expect these assessments. Many observers consider that such information and ensuing measures are critical to reduce market uncertainty so that banks can resume lending with reasonably “clean books.” 

The US stress testing exercise of the 19 largest banks covering over 60% of bank sector assets was completed by early May 2009. The results revealed that 10 banks needed to raise US$75 billion additional capital to reach the regulator’s required minimum capital level. The US authorities gave a two-month window for the banks to raise this sum primarily through private means (new issuance, restructuring existing capital instruments and asset sales); government funds were also available. All banks recapitalized from the markets by the July 7 deadline. Despite initial intense queries on scenario assumptions and methodology, market reaction has been positive, and several other banks not subject to the stress testing have since then undergone similar stress tests voluntarily, indicating the market value of the exercise.

Sweden, Greece, and recently Austria have also stress tested its banks and bank groups, and, with various degree of aggregation and disclosure, all have published the results. These have implied that additional capital may be needed for some Greek and Austrian banks, not least due to exposure to EBRD countries of operation. Greek banks have started to recapitalize from markets; the Austrian National Bank stated that it was monitoring the situation closely; support is available from the existing unutilized national support package.  In the downward end of the cycle it might not be necessary to recapitalize banks on the basis of stress scenarios as long as support “credit lines” are readily available to address unexpected shocks.

In our region, in the context of IMF programs, country-level stress testing is being performed (Ukraine, Romania, Hungary, recently Serbia), and banks are being recapitalized by their owners (typically foreign banks but also governments).

At the European level, two major stress tests have been performed to date. The ECB estimated the value of potential loan write-downs at about €283 billion in its June 2009 Financial Stability Review. The IMF’s April 2009 estimate for Europe was about multiple of that (due both to an earlier date of the exercise when the securities markets were most depressed as well as methodological differences).

 

  Currently, two major Europe-wide stress testing exercises are underway with very similar timetables.   At the request of the EFC, stress tests are being performed on the 22 EU-based largest bank groups that, as with the US, also cover over 60% of EU banking sector assets (the list is not public). There is no plan for publication of the results at this point. In parallel, the IMF is also conducting a regional stress test. As before, the IMF is expected to publish its results at least at the aggregate level, also in the autumn. Finally, several Central European countries (Czech Republic, Hungary, Poland, etc) have embarked on a harmonized stress testing of their banks, but it is unclear how far this exercise is going.

Three issues to consider:

1. Communication/publication of the results.

As a basic principle, clarity on – and, if needed, cleaning up of – bank balance sheets is important. This could be necessary so as to return to sustainable bank lending to support economic recovery.

That said, disclosure could prove to be a double-edged sword in a jittery marketplace. This is particularly important in Europe where the role of banks in financial intermediation is much larger than in the US, hence the potential for a more damaging market reaction. At the same time, market reaction to stress test results has been positive.

And there is the question if there is a choice of not to publish the results in some sense. There is peer pressure from past publications. Moreover, if markets don’t get the results, even in aggregate forms, they may assume the worst, which itself would damage confidence.

The outcome and communication would need to be coordinated with the IMF, whose stress testing results should be available at the same time.

 

  2. Financial plan for the results. The real challenge for policy makers is to prepare for the results with a credible financing plan. As with the US, financing could be a combination of private solutions and access to unutilized portions of already announced national bank support packages:

Private solutions can include new rights issues; restructuring of existing capital instruments, and asset sales (with attention to systemic impact and lending needs). In this regard, recent improvements in global financial market conditions could help.

Existing national support packages have been not been fully utilized. As of June 1 2009, of the announced total capital injections of over €311 billion, about 60% has been used. In addition, considerations could be given to converting government liquidity support instruments into equity (although to date these exist only in a few countries).

A key issue would be the burden-sharing of recapitalisation of bank groups between home and host government authorities. Cross-border ownership within advanced Europe is relatively small, yet this would be a difficult process; however, being caught unprepared is even worse, as seen in the case of Fortis. Negotiations and agreements between home and host country groups over national support and without supranational financial support has been the framework under the Vienna Initiative – perhaps a useful model.

At the margin equity investment in subsidiaries by the EBRD and IFC can also help.

 

  3. Careful application of the European Union’s Competition Policy.  The Commission has just revised, with effect through end-2010, its competition policy in the financial sector, with the objective of addressing earlier serious concerns over applying “corrective measures” that normally accompany the approval of state aid for an economic entity in an EU member state for Europe’s crisis-ridden banks of systemic importance.  The new policy appears to be more flexible – providing more time for adjustments –; focussing more on competition issues and less on “corrective measures” to cut exposures; and it is also more explicit in discouraging home-bias (see for example para. 33). That said, the new rules are likely to be tested in the context of possible recapitalisations using state aid in the context of stress tests and it will be important to ensure that EU competition policy does not encourage home market-oriented, disruptive exposure cuts to emerging Europe.

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