Written by 11:39 Financial Centre, Financial Centre, News, News

2023 EU-wide stress test: the future looks hybrid

What challenges do banks face as they prepare for the next exercise?

The European Banking Authority (EBA) has now published the final methodology for its 2023 EU-wide stress test. Macroeconomic scenarios will be disclosed before the launch of the exercise in January 2023. The timelines and methodologies are comparable to 2021, but the addition of some top-down elements represents a first step towards a future ‘hybrid’ framework. Banks should keep this future direction in mind while making their final preparations for the upcoming stress test – the results of which will inform the Supervisory Review and Evaluation Process (SREP).

The 2023 EU-wide stress test

As anticipated, the EBA will carry out its next biennial EU-wide stress test in 2023. The final methodology for the stress test, together with updated drafts of the templates and template guidance was published on 4 November, and the macroeconomic scenarios will be published before its launch in January 2023. Results are expected by the end of July 2023 and will inform the 2023 Supervisory Review and Evaluation Process (SREP).

As in previous years, the exercise will test the resilience of European banks against an adverse macroeconomic scenario, and this year it is likely to include assumptions of stagflation and further severe shocks for vulnerable sectors hit by the COVID-19 pandemic and the energy crisis triggered by Russia’s invasion of Ukraine – echoing the scenario of the Bank of England in the 2022 annual cyclical scenario (ACS) stress test for UK banks.

In terms of methodology, the key features of the stress test remain comparable to those of 2021. Banks are required to estimate the evolution of credit, market, counterparty, and operational risks under an adverse scenario, in addition to projecting the effects of the scenarios on NII and specific P&L and capital items not covered by other risk types. The static balance sheet assumption remains in place and, as in previous exercises, no hurdle rates or capital thresholds are defined.

However, some new features have been introduced. The constrained bottom-up approach remains, but it is partnered with some top-down elements and new sector-specific reporting templates. In fact, banks will be required to show how they have factored the heterogeneity of sectoral exposures and scenarios into their credit risk projections.

Finally, the sample of participating banks has increased significantly since the 2021 exercise, covering 76 banks, up from 50 banks in 2021. This represents around 75% of the banking sector assets in the Euro area, non-Eurozone Member States and Norway, up from 70% in 2021. The publication of the results will therefore expose a larger number of banks to more granular external scrutiny.

The first steps towards a hybrid approach

Many banks are likely to feel a sense of relief that the EBA reconsidered its plans to divide the 2023 stress test into two bottom-up and top-down legs. Instead, the EBA seems to be gradually introducing a hybrid framework that combines elements of both approaches. For example, one new feature is the application of prescribed growth parameters, based on top-down supervisory models, to projections of Net Fees and Commission Income (NFCI).

There may not have been a full review of the stress test framework on this occasion, but the EBA appears to be paving the way for future changes such as a potential top-down stress test for credit risk. One of the reasons for this could be that the traditional bottom-up approach gives banks more leeway to prepare their projections. Furthermore, most of the banks in the sample are largely exposed to credit risk as the main source of their hypothetical losses.

Going forward, a hybrid stress test would probably include more elements modelled centrally by the EBA. That could eventually reduce the burden for banks – a welcome change at a time where resources are spread thinly for many.

Banks face new challenges

Even if the EBA has not fully introduced a hybrid framework for the upcoming 2023 stress test exercise, the new methodological elements have already brought about uncertainties for banks – and with that new challenges. Recent discussions with banks indicate to us that their key methodological challenges revolve around the sector-specific credit risk projections, namely:

  • There seems to be uncertainty on the variables that will be covered by the scenarios, especially with respect to those that could be used by banks for the sector break-down.
  • In terms of modelling approaches, it seems that banks will mostly rely on model-driven approaches determined by sector differentiated inputs, but some banks will also resort to simpler loss distribution approaches.
  • Adjustments to the internal models are not planned by all banks and if so, they will be mostly driven by internally identified fields of improvement

Next steps

Although most banks covered by the upcoming stress test have taken part in previous exercises and the methodology is largely unchanged, banks are against the clock as they prepare for the fast-approaching start date.

It’s likely that banks will be debating how much effort to spend on adapting to the new framework, given the uncertainty over the future evolution of the hybrid approach. For now, the focus will likely be on setting up robust governance and making the adjustments to processes and systems required by the recently finalised methodology. However, the future looks increasingly hybrid, and banks should remember that the longest journeys start with small steps.

Source: KPMG
Image: Unsplash

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