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14 of the 24 German Banks who are challenged under the ECB Stress Test are represented by the German Bundesverband Öffentlicher Banken (VÖB). This organisation today published a review explaining the main traits of the EU Stress Test 2014. You can find the document under the following link.

Information on the Stress Test scenarios is published on the site of the European Banking Authority (EBA).

Central credit registers (CCRs) are granular databases operated by National Central Banks (NCBs). As Almeida and Damia state, “there are three main uses of CCRs: (1) to enable bank supervisors to accurately assess credit risk in supervised financial institutions; (2) to support financial transactions by assisting credit institutions in the evaluation of risk; and (3) for economic analysis.”
On a European level, the ESCB (European System of Central Banks) has been exploring the potential statistical use of CCRs from 2007 on. Related initiatives have proven the analytical usefulness of CCRs. To address remaining issues, the ESCB Task Force on Analytical Credit Data Sets was set up in 2013 to shed light on the following key issues:
(a) What further granular credit data does the ECB require?
(b) What data, including attributes on lenders, borrowers, credits and methodological aspects, should be collected from National Central Banks?
(c) How can data sets be shared across the Eurosystem/ESCB?
In 2014, the ECB decided that the AnaCredit project should have top priority with regard to the upcoming ECB supervisory task. AnaCredit is, simply put, “an IT solution (Analytical System on Credit – AnaCredit) for receiving, storing and disseminating credit and credit risk information on a euro area.” The quality of AnaCredit’s statistical evaluation depends on relevant input. As a consequence, the ESCB must ensure the transfer of European-wide  and harmonised credit data to the ECB by the end of 2016. Though the concrete data request is not yet finalised, it is already evident that banks shall report granular loan portfolio and borrower data on a loan-by-loan level. The statistical evaluation of this data shall support the ECB’s credit and credit-risk analysis which is required for the conduct of monetary policy, micro-prudential supervision and financial stability.

Today, the European Banking Authority (EBA) released the 2014 EU wide stress test methodology and macroeconomic scenarios.

Among others, the methodology states that the stress test is conducted on the assumption of a static balance sheet. The zero growth assumption applies on a solo, sub‐consolidated and consolidated basis for both the baseline as well as the adverse scenario. No workout of defaulted assets is assumed in the exercise. In particular, no capital measures taken after the reference date 31/12/13 are to be taken into account.

The adverse scenario is designed by the ESRB. According to the EBA, it reflects the systemic risks that are currently assessed as representing the most pertinent threats to the stability of the EU banking sector: (i) an increase in global bond yields amplified by an abrupt reversal in risk assessment, especially towards emerging market economies; (ii) a further deterioration of credit quality in countries with feeble demand; (iii) stalling policy reforms jeopardising confidence in the sustainability of public finances; and (iv) the lack of necessary bank balance sheet repair to maintain affordable market funding.

2014_0429 stress test EU

Source: Wall Street Journal

Following, please find an excerpt of the current EBA FAQ.

What is the timeline for the stress test?

The EBA expects to publish the final results of the 2014 EU-wide stress test in October 2014. The timeline has been agreed and coordinated with the ECB and is, therefore, in line with the overall timeline of the Single Supervisory Mechanism (SSM) Comprehensive Balance Sheet Assessment.

Data templates and guidelines will be distributed immediately after the launch of the methodology and scenarios in April 2014. Advance data collection will be started immediately to be completed end of May. First preliminary results are expected to be submitted to the EBA in mid-July and near-final results tentatively early September for the final round of quality checks and then absolute finalisation of the results will be just ahead of publication. Precise deadlines for the data submission of banks will be defined and communicated by the CAs.

 

How will data and results be published?

The most important aspect of the EBA’s common EU-wide exercise will be the disclosure of comparable and consistent data and results across the EU. Results will be disclosed on a bank by bank basis and the EBA will act as a data for the final dissemination of the outcome of the common exercise. The level of granularity of the data disclosed will be at least consistent with that of the 2011 EU-wide stress test and 2013 EU-wide Transparency Exercise. It will include the capital position of banks, risk exposures and sovereign holdings.

The credibility of the EU-wide stress test rests on transparency; market participants will be able to determine for themselves how supervisors and banks are dealing with remaining pockets of vulnerability.

Summary: The AQR treatment on accounting impairment demonstrates how important prudential valuation can be in the future if the ECB continues to use it. In this case, banks will have to consider the differences between accounting and prudential valuation to ensure an adequate and integrated capital and balance sheet management, as long as accounting impairment is based on the incurred loss model. A reliance on accounting valuation to manage the balance sheet may not suffice. 

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The three elements of the Comprehensive Assessment are the Supervisory Risk Assessment, the Asset Quality Review (AQR),  and the Stresstest. Together, these elements provide an in-depth understanding of material balance sheet risks. As economic risks are linked to balance sheet calculation, it is crucial to differentiate between the application of adequately interpreted accounting rules on one side, and the prudential adjustments required by the Comprehensive Assessment on the other side. The latter shall assure a proper and (more) harmonised calculation of the CET1 (Common Equity Tier1). Both, the identification of prudential balance sheet adjustments and the recalculation of CET1 is be part of the AQR. The AQR itself comprises three key phases:

  • portfolio selection: result- identification of exposures with the highest risk and portfolios which should be included in the execution phase; status: completed
  • execution: result:-identification of prudential balance sheet adjustments ; status: on-going
  • collation: result- AQR adjustment calculation to CET1; status: scheduled for July 2014

With respect to the close relation between accounting and prudential valuation it is important to note that the “AQR should not be seen as an attempt to introduce greater prescription into the accounting rules outside of the existing mechanisms.” Among others, the following questions arise:

Impact of the prudential AQR valuation adjustments on bank accounting: The ECB states that “Banks would not be expected to incorporate into policies, processes or reporting findings from the AQR that relate to a bank failing to be the right side of the ECB threshold if they are compliant with the relevant accounting principles. The bank would not be required to restate accounts or apply the AQR assumptions on an on-going basis, i.e. the AQR-adjusted CET1% is not a de- facto alternative accounting standard.”

Treatment of prudential adjustments on accounting valuation in the course of the Comprehensive Assessment: “The AQR will generate a series of parameters that will act as inputs to the stress test process. The key inputs to the stress test will be: any adjustments to data segmentation highlighted by DIV, an AQR-adjusted Common Equity Tier 1% (CET1%) parameter (to allow the impact of the AQR to be applied to stress test projections of the CET1%) and probability of Impairment (PI) and Loss Given Impairment (LGI) parameters for use in the stress test. The way these parameters will be used in the stress test is pending the final methodology for the stress test, which is currently underway. As mentioned, the AQR-adjusted CET1% will be used to compute the final stress test outcomes.” One follow-up action of the ECB can be, however, to ask banks to capitalise for a shortfall relative to the ECB threshold in incremental Pillar 2 capital requirements.

Consequences if the ECB concludes that the accounting rules used by the bank are not in line with best practice interpretations: Following completion of the Comprehensive Assessment, “NCAs will produce a letter to significant banks outlining any areas where the bank is found to be outside of accounting principles and the required remediation actions the bank would be expected to take (including adjustments to the carrying values of assets). These issues would be expected to lead to adjustments to available capital and hence be reflected in Pillar 1 capital requirements at the next relevant reporting date. For the purposes of clarity,  areas where the bank falls short of the “ECB threshold” but is in line with accounting standards would not be included in the letter to the bank.”

The  case of prudential impairment calculationIAS 39, Para 59 (EU) states: “A financial asset […] is impaired and impairment losses are incurred if, and only if, there is objective evidence of impairment as a result of one or more events that occurred after the initial recognition of the asset (a ‘loss event’) and that loss event (or events) has an impact on the estimated future cash flows of the financial asset […] that can be reliably estimated. It may not be possible to identify a single, discrete event that caused the impairment. Rather the combined effect of several events may have caused the impairment. Losses expected as a result of future events, no matter how likely, are not recognised. […]” The ECB defines the following approach in its AQR-Phase2-Manual: “Initially, the NCA bank team will compare the impairment triggers of the significant bank as of December 31st with the minimum triggers provided in Table 38 of the manual and the loss events stipulated IAS 39. Where the significant bank has defined additional or more conservative triggers, these should also be taken into consideration in addition to the minimum triggers. This implies that the evidence of impairment definition is at least as conservative as the significant bank’s current classification.The NCA bank team should assess each exposure in the sample for objective evidence of impairment on December 31st 2013. This requires a two-step approach:

  • First, assessment for each exposure whether a loss event has happened based on the triggers provided. Not all of the triggers apply to each debtor (e.g. CDS is not relevant for retail mortgages or large SME).
  • Second, for each exposure with a loss event, the assessment whether the loss event has an “impact on the estimated future cash flows” of the exposure. If this is the case, the exposure will be considered as having evidence of impairment.“

In contrast to the above mentioned criteria, current or past cash flows do not necessarily need to be impacted for an exposure to be considered impaired according to IAS 39. Additionally “NCA bank teams will classify exposures as having evidence of impairment irrespective of whether the impacted future cash flows indicate that an impairment loss should be registered (i.e. impaired loans where impairment loss is assessed as 0 due to collateral should be viewed as being impaired because cash flows will be impacted by the foreclosure of collateral).”

2013 was a year full of new regulatory impulses. 2014 is the year of major changes in Bank Regulation and Supervision.
The ECB Supervisory Board convened for the first time this year in January.  Following this meeting, Ms. Nouy, Chairperson, stated: “We have to accept that some banks have no future,” and: “We have to let some disappear in an orderly fashion, and not necessarily try to merge them with other institutions.” This statement is remarkable as main preconditions to restructure the European financial system are still work in progress. Current issues are:
         Which banks „have no future“?
         Who decides if a bank shall be liquidated?
         Who pays for it?
Banks with no future: Since February this year, Joint Supervisory Teams and auditors collaborate to conduct an on site Asset Quality Review.  Its outcome is meant to identify European banks that might be restructured or liquidated if they do not meet the thresholds set by the joint ECB and EBA stress tests. Final results of the Comprehensive Assessment are expected in October 2014 at the latest. We expect further stress tests to follow.
The decision to liquidate a bank and the source of the funds required to do so: These are major issues currently discussed by the European lawmakers, which are scheduled to be resolved until April 2014 before the EU parliament adjourns for May elections.
Last week’s negotiations between EU precidency, commission, parliament and council established the following concerning the resolution decision:
  • The ECB will be charged with the task of determining if a bank is failing or likely to fail.
  • The committee which will be charged with the decision upon the resolution of a bank is still in discussion. German Finance Minister Wolfgang Schäuble suggests decision making shall take place through the plenary session of the Supervisory Board. Other interested parties are asking for more independence from national influence and favor a decision by the Executive Board. The final decision lies either with the commission or the council.

Concerning the funding of the resolution costs it appears that Finance Ministers across the EU recognize a common need to demonstrate the European financial system’s robustness in a crisis. Clearly, the time period allowed for the SRM fund’s pooling will be key to signaling this strength. Accelerated funds pooling and/or an additional backstop such as the ESM are possible approaches. Details are currently debated as well.

In view of these developments, movement toward restoring market credibility and restructuring the European financial system can be seen. The question remains: Who pays the bill? The ongoing negotiation on the SRM funds are connected to points already set in 2013: SRM funds shall only be used after Bail-In has taken place. The Bail-In rules will enter into force on January 2016, together with the pooling of SRM funds.
In the meanwhile and with respect to the 2014 Comprehensive Assessment results, EBA and ECB asked the European Finance Minister to help banks “disappear in an orderly fashion“ by making sure that there are national resources available to carry potential recapitalisation or resolution costs. It is essential that each country contributes its part. This understanding is also mirrored by the  ESM-regulation. It states that ESM funds shall only be used for direct bank recapitalisation if the respective country cannot provide the required stake.