In December 2018, the EBA announced that it would carry out the next European banking stress test in 2020. Thereby it remains true to its current rhythm of carrying out either a comprehensive stress test or a so-called transparency exercise every two years.
The 2018 stress test brought significant changes in the methodology for credit risk in order to adequately comply with the new accounting requirements under IFRS 9. But significant methodological changes can also be expected for 2020. This is because regulatory changes had to be taken into account in past stress tests if they had already been adopted and had entered into force during the time horizon of the stress test (cf. Text 22 of the EBA Methodology 2018).
Three new regulatory requirements are presented below, which will find their way into the 2020 methodology of the EBA and are likely to have a major impact on it.
The revised default definition
Already in 2016 the EBA published a guideline for the interpretation of the default definition according to Art. 178 CRR. The requirements are to enter into force on 1 January 2021 and apply to both IRBA and CR SA banks. This would fulfil the condition set out in the methodology, requiring it to be a publicly adopted new regulation that will enter into force within the time horizon of the stress test (2020 to 2022).
In terms of content, this means for banks that they must already take into account the specifications of the new default definition when modelling the probability of default (PD) and the loss given default (LGD) as part of the stress test. Historical default and loss rates must be recalibrated to meet the changed requirements. As a result, rising default rates and thus a deterioration of the capital ratios are to be expected.
Non-performing exposure backstop
In April 2019, an amendment to the CRR introduced a mandatory backstop for non-performing exposure. This requires banks to deduct from capital positions that change to non-performing status after the amendment has entered into force, as far as they have not already been covered by credit risk adjustments or write-offs. The amount of the capital deduction depends on any existing credit risk mitigation techniques and rises to up to 100% within a specified period of time.
Since the backstop requirements have thus already entered into force, they would also have to be consistently taken into account in the 2020 stress test. Newly defaulted positions would therefore not only have to lead to an increase in provisions in accordance with the 2018 methodology, but also to an increase in the corresponding capital deduction, especially for uncollateralised positions.
New securitisation framework and CRR II
Since the beginning of 2019, new requirements for determining capital requirements for securitisations have entered into force. In the 2018 stress test, these were still explicitly disregarded. In 2020, however, they will have to lead to an adaptation of the stress test methodology. Due to the increase in the complexity and data intensity of the new approaches, it is to be expected that the methodology for determining stress will also become more complex.
Finally, CRR II came into force in 2019. Since the material provisions of CRR II are to be applied two years after their entry into force, they also fall within the 2020 EBA stress test period. The main effects on risk-weighted assets are as follows:
- Extension of the SME factor to positions < 1.5m EUR
- New specifications for shares in investment funds in the banking book
- Determination of exposure value for derivatives using SA-CCR
Due to the delayed entry into force of the new market risk regulations, however, it is not to be expected that the Fundamental Review of the Trading Book will also have to be taken into consideration as part of the 2020 stress test. Furthermore, the other Basel IV reforms that have not yet been addressed in the CRR II framework (CR SA, IRBA, CVA, OpRisk, Floor) should not be taken into account in the stress test, as their implementation in the EU has not yet been endorsed – and probably will not be until the start of the 2020 stress test.
2018 variant. Instead, the necessity for numerous methodological adjustments is already foreseeable. For banks, this means that they must expand their existing calculation methods and add the new components. In particular, the data-hungry and complex calculations for securitisations and derivatives can turn out to be cost drivers.
The same applies to changes to the default definition. Together with the non-performing exposure backstop, they are likely to lead to a deterioration in banks‘ results. Accordingly, in addition to adjusting the calculation methods, strategic measures should also be considered, in particular around the reporting date of the stress test at the end of 2019.
A first draft of the revised methodology is expected to be published by the EBA in the summer. If you need assistance with the preparation and derivation of recommendations for action for your institution, please do not hesitate to contact us.
Phone: +49 69 9585 3841
Mobile: +49 151 1462 3842