ECB and Fed Reserve stress tests highly anticipated
(6 February 2019 – Europe) The European Central Bank (ECB) will dictate to European Union (EU) banks how many days they could withstand a bank run on deposits under a new stress test introduced this month while US bank stress tests conducted during an “interim” period this year will help the Federal Reserve decide what permanent changes to make to the closely followed examinations.
Over the next quarter regulators at the ECB’s Single Supervisory Mechanism (SSM) will simulate “adverse and extreme hypothetical shocks”, such as consumers and businesses pulling out cash rapidly, at up to 100 banks. The test is a response to bank runs hitting Spain’s Banco Popular and other euro zone banks in recent years, the results of which may feed into how much cash and capital each bank is required to hold. Under the test’s “extreme shock”, a bank is hit by a major run on deposits, a freeze in wholesale funding, a three-notch downgrade to its credit rating and pronounced withdrawals in committed credit lines, all in the course of six months. The test draws on the ECB’s experience as the euro zone’s top banking supervisor since 2014. That shows banks find it hard to cut back lending fast enough in response to cash crises, which normally last four to five months, the ECB said. The results, which will be published on aggregate in the second half of the year, “may lead to additional liquidity requirements” and are designed to lay bare weak spots in how banks manage their cash.
The exercise will be based on bank data as of the end of last year, which reflects ample liquidity supplied by the ECB itself. It won’t take into account possible changes to its monetary policy. It will also focus on the situation of individual banks and won’t simulate situations when banking as a whole is under pressure from a macroeconomic or geopolitical crisis. “The exercise will focus on banks’ expected short-term cash flows to calculate the ‘survival period’, which is the number of days that a bank can continue to operate using available cash and collateral with no access to funding markets,” the ECB said.
The US Federal Reserve stated that it would make its stress testing of large banks more transparent in 2019, providing financial firms significantly more information about how their portfolios would perform under potential economic shocks. The changes respond to long-running bank complaints that the current stress-testing process is cumbersome and opaque. The stress tests are a major yearly event for the largest banks, as they cannot distribute capital through dividends, share buybacks, or other investments without clearing that Fed hurdle. Thirty-four lenders passed the test last year, while Goldman Sachs and Morgan Stanley received conditional approvals that limited their capital distributions. The U.S. subsidiary for Deutsche Bank had its capital plan rejected by the Fed. “Our challenge now is to preserve the strength of the test, while improving its efficiency, transparency, and integration into the post-crisis regulatory framework,” Federal Reserve Vice Chairman of Supervision Randal Quarles said in remarks prepared for delivery at a Council for Economic Education event in New York. “Our experience with this ‘interim’ year will inform the move to a permanently longer testing cycle - a change that would, of course, be subject to a full notice and comment process.”