The EU financial system will be stress tested in 2023 by assessing the performance of banks under a baseline and adverse scenario during the 2023-25 period . The adverse scenario assumes a hypothetical worsening of geopolitical tensions leading to a severe decline in GDP with persistent inflation and high interest rates . This exercise aims to evaluate the resilience of banks and identify potential vulnerabilities within the financial system. By analysing the impact of different stress scenarios on banks, regulators can take necessary measures to ensure the stability and robustness of the financial sector .
EU stress test
The European Banking Authority (EBA) has launched its annual EU-wide stress test for 2023, with the objective of assessing the solvency and resilience of 70 EU banks under a hypothetical adverse macroeconomic scenario over a three-year period. This year's stress test is significant as it includes European entities of third country banks for the first time, providing a deeper understanding of the similarities and differences across jurisdictions. The adverse scenario involves hypothetical heightened geopolitical tensions, high inflation, and higher interest rates, making it the most severe scenario used in EU-wide stress tests so far.
The sample size of this year's stress test is larger than in previous years, covering 20 more banks than in 2021, which represents 75% of the EU's total banking assets. The stress test is a critical tool for assessing the resilience of the European banking sector and ensuring that banks have adequate capital buffers to withstand severe shocks. The EBA is expected to publish the results of the exercise at the end of July 2023, which will provide valuable information for supervisory authorities and market participants.
AFME (Association for Financial Markets in Europe) has released a statement welcoming the stress test, acknowledging that it will provide insights into the reversal of interest rate levels back towards long-term trends, which is one of the most pressing macro-financial issues. However, AFME has also noted that the EBA methodology has placed undue restrictions on banks' interest earning capacity, which may negatively impact the assessment of banks by investors.
In parallel, the European Central Bank will also conduct its own stress test for an additional 42 medium-sized banks that are not included in the EBA sample due to their smaller size. The ECB will apply the same scenarios as well as elements of the EBA methodology. This year, banks will use prescribed parameters for net fee and commission income for the first time. Furthermore, banks will report their provisions for expected losses at a sectoral level based on sector-specific projections in the scenarios. The results will be used to update each bank's Pillar 2 Guidance in the context of the Supervisory Review and Evaluation Process (SREP).
The EBA has published a methodology, template guidance, template scenarios, and FAQs on its website for the stress test. The objectives of the stress test are to assess and compare the overall resilience of EU banks to relevant severe economic shocks, assess if bank capital levels are sufficient to ensure banks can support the economy in periods of stress, foster market discipline through the publication of consistent, granular, and comparable data at a bank-by-bank level, and provide input to the Supervisory Review and Evaluation Process (SREP) for competent supervisory authorities.
In summary, the 2023 EU-wide stress test launched by the EBA is a crucial exercise that assesses the solvency and resilience of EU banks under a hypothetical adverse macroeconomic scenario over a three-year period. The stress test aims to provide valuable input for assessing the resilience of the European banking sector in the current uncertain and changing macroeconomic environment. The inclusion of European entities of third country banks for the first time is an important development, and the results of the stress test will provide valuable information for supervisory authorities and market participants.
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