Raising a low bar

29 April 2014 By George Hay Follow @gfhay

The European Banking Authority’s macroeconomic assumptions for its 2014 exercise aren’t as harsh as they could have been. But the methodology will encompass sovereign risk, and harmonised balance sheets will add rigour. Unlike prior efforts, the test should avoid becoming a joke.

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Europe-wide bank stress tests due to be released in October will assume a 7 percentage point decline in European Union GDP from baseline assumptions, according to methodology divulged by the European Banking Authority on April 29.

The adverse scenario assumes a cumulative deviation of EU GDP from its baseline level by 2.2 percent in 2014, 5.6 percent in 2015, and 7 percent in 2016. EU unemployment is higher than its baseline level by 0.6 percentage points in 2014, 1.9 percentage points in 2015, and 2.9 percentage points in 2016.

The adverse scenario also envisages a 150 basis-point increase in bond yields in the European Union in 2014, and around 110 bps in 2015-16. Hits to sovereign debt held in banks’ so-called “available for sale” sections of their balance sheet will hit capital on a progressively more punitive basis.

The cumulative fall in house prices for the EU is 14 percent compared to the baseline by the end of 2016, while equity prices are assumed to go down by 19.2 percent by the same date.

The EU-wide stress test will be conducted on a sample of 124 banks covering at least 50 percent of each national banking sector. It will include a shock to the commercial real estate sector, as well as a foreign exchange shock in central and eastern Europe.

Capital shortfalls should be covered within six months for those identified in the AQR or the baseline stress test scenario, and within nine months for those identified in the adverse stress test scenario, the ECB said on April 29.

Baseline capital holes have to be filled with core Tier 1 equity, while adverse shortfalls can be filled with additional Tier 1, with higher trigger AT1 eligible to cover more of the shortfall than lower-trigger versions.

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