After the bi-yearly EBA / ECB stress test was cancelled in the wake of the COVID-19 crisis at the beginning of 2020, it has now become finally clear that the exercise will be brought to an end in 2021. This has already been stated by the EBA on its homepage and was also included in the EBA’s 2021 work program. And also those banks that are part of the ECB’s rather than the EBA’s sample of participants have by now received the information that they are once again required to participate. Hence, it’s time to take again a closer look at the upcoming exercise and to get prepared for potential amendments due to the current economic and regulatory environment.
2020 all over again – what news could the 2021 exercise bring?
In its statement on the launch of the 2021 stress test exercise, the EBA covers the timeline and sample of banks, but does not comment on the methodology to be followed in 2021 or the scenarios. As a major review of the methodology is currently being prepared (see below), it obviously makes sense to use the methodology and templates already prepared for the 2020 exercise, rather than inventing something new. However, there are at least three key areas in which innovation for the 2021 exercise would be plausible:
- Macroeconomic scenario: the macroeconomic downturn expected as a result of the COVID-19 crisis is still not yet fully clear with regard to its duration and severity. However, the consensus view is that it will have a bigger impact on banks than any of the recent EBA / ECB stress tests. So on the one hand, supervisors will need to make use of a more severe scenario to have a credible exercise. On the other hand, this scenario would be applied in 2021 to banks that already suffer from a stressed environment rather than the benign macroeconomic circumstances in place before COVID-19 hit. Scenario design will therefore be a major challenge for the 2021 exercise in which resorting to the 2020 scenario is not an option. This is even more true now that a second wave is obviously well under way and most moratoria have run out already. Banks might feel the impact of COVID-19 in the coming months probably even more than in the last quarter. It will also be interesting to compare the scenarios to be developed with internal assumptions used by banks. If large differences emerge between both, banks might need to justify their more optimistic assumptions for example when it comes to IFRS 9 provisioning which is subject to the 2020 year-end audit.
- CRR 2: the changes to capital requirements caused by CRR 2 were all but excluded in the 2020 methodology despite the fact that they will (for the most parts) be applicable from June 2021 and therefore in the time span that is being looked at as part of the stress test. Now, a couple of CRR 2 effects has been accelerated as part of the CRR quick fix and the applicability of the other effects is obviously closer than it was one year ago. Not reflecting these in the methodology would further impair the relevance of the results of the exercise.
- COVID-19 impact: one of the most important elements of the CRR quick fix was a revision of the IFRS 9 transitional provisions to shield the own funds of banks from the impact of increased provisions on Level 1 and 2 assets caused by the pandemic. In effect, if banks use this transitional rule, they would not account for any increase in provisions on performing exposures in their regulatory capital ratios in 2020 and 2021 and only a severely reduced part of any increase in 2022 and 2023. Given that the ECB proactively urged banks to make use of this rule, the ST methodology will need to take it explicitly into account as – if applied as foreseen in CRR – this would render any credit risk stress almost meaningless for the calculation of stressed capital ratios.
While this is probably the best example of how supervisors’ reaction to COVID-19 might impact the stress test, other such interdependencies exist as well, for example exceptions granted with regard to market risk internal model multipliers or moratoria granted that continue to be applicable in 2021 and beyond.
Overall, the changes in the macroeconomic environment as well as the regulatory reaction to these changes in turn make changes to the proposed 2020 EBA scenario and methodology necessary to make the 2021 stress test a meaningful exercise.
Looking to the future – a new methodology on the horizon?
In addition, the EBA also mentioned on its homepage the significantly revised stress test methodology that has been consulted at the beginning of 2020 and should have been the basis for the supervisory stress test starting from 2022. In this regard, the EBA proposes to move this new methodology to 2023, i.e. rather than having one exception in 2021 and then returning to the old rhythm of having stress tests in even years, uneven years will be the norm in the future. There is no hint as to whether the new methodology as proposed in the consultative paper will be used in 2023 or if further revisions are to be expected. The 2021 work program only notes that the preparation of the 2023 stress test is ongoing, as is the work to include climate risk into stress testing.
This blog argues that the 2021 EBA / ECB stress test cannot simply bring to an end the exercise that was postponed in 2020 but will by necessity include some changes to scenarios and methodologies. This might seem a waste of effort given that a major renovation of the framework for supervisory stress testing is being consulted at the same time. However, given the changes brought about by COVID-19 and CRR 2, these changes are indeed required to make the 2021 exercise a meaningful one.
When preparing for the 2021 exercise, feel free to reach out to PwC’s stress test experts that have supported several banks in supervisory stress testing since the inception of the EBA / ECB stress test.