EU to conduct stress test on banks

The EU will conduct its toughest test ever to determine their preparedness to withstand shocks

In a test that surpasses that used by the Federal Reserve for its health checks of U.S. lenders, the EU will conduct the toughest stress test on banks this year to determine their ability to withstand theoretical shocks.

The stress test, which will include 48 banks, will also consider the impact of brexit – the EU’s banking watchdog said on Wednesday. The outcome of the stress test will shape capital requirements policed by regulators like the European Central Bank (ECB) which supervises 33 of them. There will be no pass or fail mark for the banks taking part in the test.

The European Banking Authority (EBA) said that the stress test is designed to provide supervisors, banks and other market participants with a common analytical framework to consistently compare and assess the resilience of EU banks to economic shocks.

The “adverse scenario” of the bi-annual health check is an 8.3 percent cumulative fall in growth by 2020 from the “baseline” scenario based on real central bank forecasts. The adverse scenario considers a wide range of macroeconomic risks that may be associated with Brexit.

The test considers a scenario by 2020 in which inflation falls by 1.9 percent, unemployment jumps by 3.3 percent and home prices fall by 19 percent. For the first time, the EU test will reflect new international accounting standards that force banks to make up front provisions on loans in case they turn sour.

The major book-keeping reform applies lessons from the 2007-09 financial crisis that found lenders too late in finding cash to cover defaulting loans.

The test will also determine the coping ability of banks in case of a general economic downturn, increased market volatility and political uncertainty that may theoretically be triggered by Britain leaving the bloc in March 2019. The test is similar to one done by the Bank of England last year to look at the potential impact of a “hard” Brexit or Britain leaving the bloc without new trading terms. The EU test will also assume an abrupt and sizeable repricing of risk premium in global markets, and the impact of weak growth and poor profitability.

EBA said that this will affect, in particular, banks in those countries facing structural challenges in their banking sector.

Other factors include new worries over public and private debts, and how lenders will cope with a sell-off in assets by non-banks which sent assets they held plummeting.