EBA’s Stress Test 2020 Methodology – What’s new for the banks?

EBA’s Stress Test 2020 Methodology – What’s new for the banks?

Fri 29 Nov 2019

The methodology for an exercise to assess the resilience of EU banks to adverse market conditions and test the state of their capital allocations has been released by the European Banking Authority (EBA).

The exercise – part of EU-wide stress testing – will apply to broadly 70% of the European banking sector[1]. Some 52 banks have been scoped in, based on their total consolidated assets (minimum of EUR 30 bn). As the UK will be subject to EU law when the test begins in January 2020, four British banks are still included in the sample.

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The EBA publication offers the bank’s guidance on the test performance, and the common methodology that will define how the ‘stress impact’ of common scenarios should be calculated. Simultaneously it is setting up constraints for bottom-up calculations: banks are required to project the impact of defined scenarios while subjected to strict constraints and to a thorough review by competent authorities.

In accordance with 2018

The stress-test scenarios will be applied over a three-year period – from the start of 2020 until the end of 2022, and the exercise will be carried out based on year-end 2019 figures. Its impact will be reported in CET1 capital, while Tier 1 capital ratio, total capital ratio, and leverage ratio will be reported for each year of the 2020-2022 period.  The use of new internal models and modifications is obligatory if those are approved before 31 December 2019.

Similar to the previous exercises, the EU-wide stress test shall be conducted on the assumption of a static balance sheet – for both the baseline and the adverse scenarios. IFRS9 standard, which has a mandatory effective date for annual periods beginning on or after 1 January 2018, was already implemented in stress test 2018.

The primary focus of the stress test will be the assessment of the impact of risk drivers on the solvency of banks: credit risk – including securitization, market risk – CCR (counterparty credit risk) and CVA (credit valuation adjustment), and operational risk – including conduct risk. Additionally, banks need to evaluate the effect of the stress scenarios on NII (net interest income), and P&L and capital items not covered by other risk types.

New regulation; potential impact

New Default definition can be considered when modelling the probability of default and loss given default. The actual standard[1] establishes a uniform materiality threshold (with an absolute and a relative limit) for overdue receivables within the EU jurisdictions. The deadline for the implementation of this requirement is 1 January 2021. By then, the banks must have implemented it into their internal process and IT systems. The new definition should be used in the stress test, and an impact assessment of the new definition when compared to previously implemented shall be included in the explanatory note, only if the banks have implemented it in their systems by 31 December 2019. In this case, the risk parametre estimates should be reviewed and adjusted, and the historical failure rates must be recalculated, with the effects on risk weighted assets re-estimated if necessary.

The CRR Amendment[2] from April 2019 introduces a mandatory backstop for non-performing exposure which shall be reflected in the 2020 EU-wide stress test. The regulatory capital provision for NPEs is a new control parameter, and banks should deduct from capital positions that change to non-performing status, if they have not already been covered by credit risk adjustments or write-offs. Defaulted positions would have to lead to an increase in provisions in accordance with the 2020 EBA methodology, as well as to a rise in the corresponding capital deduction, for uncollateralised positions – in particular.

The CRR II[3] – the second amendment of the Counterparty Credit Risk regulation, came into force in 2019, but the material provisions outlined in it are to be applied by banks by 28 June 2021. Hereafter, only if the banks have implemented the requirement in their system by 31 December 2019, they will consider it in the stress testing.

The new EU securitisation framework[4] shall be taken into consideration when determining capital requirements, which in 2018 were still disregarded. The 2020 stress test methodology was adapted to comply with the new EU Securitization Framework, hence adding extra complexity and data intensity.

Results and timeline

The results of the EU-wide stress test, on a bank-by-bank basis, and in the form of aggregated analyses and reports, will be published by the EBA on common disclosure templates. The data which comes out, will be fed to the supervisory review and evaluation process (SREP) performed by the National Competent Authorities.

Article written by Meglena Grueva, Mazars Frankfurt

[1] Banking sector in the euro area, each non-euro area EU Member State and Norway

[1] Guidelines on PD estimation, LGD estimation and treatment defaulted exposures

[2] Regulation (EU) 2019/630

[3] Regulation (EU) 2019/876

[4] Regulation (EU) 2017/2402