Methodology used for EU bank stress test

The Committee of European Banking Supervisors (CEBS), made up of regulators from the 27 EU member countries, looked at the banks under three scenarios that replicated another recession that culminates in a once in every 20 years crisis.

Those banks unable to maintain a Tier 1 capital ratio of at least 6 percent by the end of 2011 under the most adverse scenario used in the test were deemed to have failed.

The following outlines basic parameters of the test -- the second carried out in two years by CEBS -- and main criteria in the three scenarios:

Basic Parameters

The 91 banks hold 65 percent of the EU's total banking assets and at least half of banking assets in each of the 27 EU countries. The banks are tested on a consolidated basis so their subsidiaries elsewhere are included.

The base is a bank's situation at the end of 2009 and the scenarios cover a moderate recession over 2010 and 2011. All banks were asked to complete the same test templates that looked at risks on trading and banking books, including exposures to home, corporate and interbank loans, interest rate volatility and credit risks.

The test did not look at liquidity levels because of a separate study being done by CEBS and the Basel Committee in relation to new global liquidity rules.

Banks were asked to calculate losses on loan books and securities under several scenarios. These were offset against expected earnings in 2010 and 2011. The result was deducted from Tier 1 capital. Meanwhile, risk-weighted assets rose to reflect increased risks.

The ECB gave banks guidelines for the probability that certain classes of loans would default, and the likely loss they would suffer. Big banks were allowed to use their own models to estimate losses, though under supervision of local regulators.

Banks failed the test if they were unable to maintain a Tier 1 capital ratio of 6 percent under each scenario. Under existing regulatory requirements, banks must hold at least 4 percent in Tier 1 capital but many of the bigger banks hold far more.

The average Tier 1 capital ratio rose from 8.3 percent at the end of 2008 to 9.9 percent at the end of 2009.

The stress tests were done after the recapitalizations of banks in Europe while the U.S. test done last year was conducted prior to recapitalization.

Benchmark Scenario

This is not a stress test but a basis for comparing the two following stress test scenarios. It is based on existing forecasts for EU economic growth issued by the European Commission until the end of 2011.

The benchmark also assumes that stock markets fall 10 percent in 2010 and 2011, a cumulative drop of 19 percent.

Adverse Scenario

This imagines a double dip recession hitting Europe.

It assumes a cumulative average drop of 3 percent in economic growth over 2010 and 2011, representing a bigger drop in countries like Germany whose economy is very open to fluctuations in trade.

Equity holdings in the available-for-sale portfolios were stressed to assume stock markets plunge 20 percent in both years, a cumulative rout of 36 percent that puts shares deep into bear market territory.

The test assumed that credit ratings on holdings of securitized products were downgraded by four notches across the board.

Regulators also assumed that short-term interbank borrowing rates rose by 125 basis points -- similar to the aftermath of Lehman's collapse -- for the entire two years. Long term rates were assumed to have risen by 75 basis points.

The stress adjusted the probability of default (PD) and loss given default (LGD) for loan portfolios under various scenarios.

CEBS said the test on the banking book stress both the numerator and denominator for capital ratios -- reducing the capital held, and increasing the risk weighted assets.

CEBS and the European Central Bank believe its scenario has a probability of happening once in every 20 years, which they say is a more severe test than U.S. regulators carried out on their banks last year, which was based on a once in every seven years probability.

Adverse Scenario with Sovereign Debt Shock Add-On

In May, European leaders added a third scenario after market concerns over bank exposures to the falling value of the sovereign debt of peripheral euro zone countries like Greece, Spain and Portugal.

This scenario includes an add-on whereby severe turmoil in government bonds are included.

Under this scenario, long term interest rates rise by a further 30 basis points in the euro area.

Based on the value of the bonds at the end of 2009, the "haircut" or discount on five-year Greek bonds at the end of 2011 would be 23.1 percent, with the equivalent for Portuguese, Spanish and German bonds set at 14 percent, 12.3 percent and 4.7 percent, respectively. The same haircuts were applied to all government bonds, regardless of maturity.

The scenario does not assume that any default on a government's bonds as this was felt to be a "highly implausible" event. As a result, the "haircuts" only apply to bonds held in the trading book, although the sovereign stresses do feed into credit losses in the banking book.

Despite this, each bank is expected to spell out its holdings of government debt for all EU countries. This disclosure separates the trading and banking book holdings, and reports both gross and net positions, taking account of hedging contracts.

[Source: Reuters, London, 26Jul10]

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