Top Down Robustness Check of the 2014 EBA Stress Test

By 25/11/2014Research

Complementary Online Stress Test Analytics

OSIS provides credit data validation, visualization and modeling tools and services. An interactive analysis of the 2014 EU-wide stress test results from EBA (EBA ST) can be found on our website www.os-is.com/assetquality-review-stress-testing/. This article supplements the freely available online tool to analyze the EBA stress test data. A number of interactive visualizations are available to compare the stress test results across banks, countries and exposure classes.

Abstract

In this paper we motivate and explain our online analysis of the 2014 EBA ST and show how banks and investors can use the published data to better understand bank balance sheets with a particular focus on credit risk. The results of the EBA ST provide unprecedented insight in the sensitivities of banks’ credit risk to macro economic changes. With up to 12,000 data points per institution it provides the most detailed stress test disclosure to date, offering unique insight into the bank balance sheets which are generally considered too opaque for a detailed credit risk analysis from the outside. The EBA ST was a bottom up exercise allowing the 123 participating banks to use their own models to calculate projected losses and risk weighted assets. We document the significant variations between banks with regards to the risk parameters and sensitivities used to arrive at the published development of their capital ratios under stress. Such variability has been known for the bank’s own determination of risk weighted assets(RWA) under the Basel internal ratings based approach and our analysis shows that the large variability for RWA persists. While the quality assurance documentation from the ECB and EBA emphasizes consistency between institutions, our analysis suggests that large differences remain and that investors are well advised to conduct their own top down analysis with consistent assumptions across institutions. We estimate the point-in-time probability of default (PD PIT) and regress it against the given macro scenarios resulting in a library of tens of thousands of credit risk models by bank, country and exposure class. We draw the analogy between the asset correlation in the Basel framework for RWA and the macro sensitivities used in the stress test. In Basel, the asset correlation is given by supervisors and the same correlations are applied across all countries worldwide. The correlation values prescribed are generally considered conservative to capture some of the variability between countries and model uncertainty more generally. In the EBA ST, the role of the asset correlation is played by the macro sensitivities which are equally hard to determine accurately from historical data requiring long time series that are often lacking. In the EBA ST, the macro economic scenarios vary country by country and we find that the country-averaged sensitivities used by the banks vary by more than one order of magnitude. Finally, we use the estimated models to recalculate the Core Tier 1 ratios based on more homogenous assumptions while still accounting for the bank’s individual starting points. Our results suggest that some large institutions would have failed the stress test had they not used more aggressive assumptions compared to the average of their peers by country and exposure class. If one believes that banks were on average accurate in their impairment projections, then the total capital shortfall in the banking system will only differ moderately using more homogenous top down assumptions. If, however, the macro sensitivities are used at a required level of conservatism (e.g. using parameters at the 75% or 90% credibility level), then materially larger capital shortfalls would have been revealed.

Introduction: The 2014 EU-wide stress test

The joint 2014 stress test by EBA and the ECB forms part of the Comprehensive Assessment (CA) which includes the Asset Quality Review (AQR) and provides an unprecedented level of disclosure on the quality and vulnerability of the balance sheets of the largest banks in Europe. A major objective of the stress testing exercises is the fostering of market discipline, i.e. allowing market participants to conduct their own analysis of the banks’ balance sheets as we attempt in this work. Our contribution aims to help banks and investors to conduct a like-for-like comparison of the published results. Our approach is based on public data, but is otherwise similar to quality assurance procedures conducted by the supervisory authorities which, however, have remained unpublished to date. We conduct a partial robustness test with regards to credit risk and provide tools for a coherent top down analysis of loan impairments, which for a commercial bank is by far the largest individual source of capital erosion under stress.

November 2014

To get the full unabridged version, please contact us at info@os-is.com

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