Until the 2007-2009 Great Financial Crisis (GFC), regulatory stress testing practices in financial institutions were limited to banks following the Internal Rating-Based (IRB) Approach for Capital Requirements for Credit Risk under Basel II. Banks were required to stress test their IRB models under different scenarios like economic downturns, market risk events, or liquidity conditions. In May 2009 the Basel Committee on Banking Supervision (BCBS) published its “Principles for sound stress testing practices and supervision” designed to address the weaknesses in stress testing practices as highlighted by the global financial crisis.
The BCBS publication led the CEBS to establish a target date for the implementation of these principles and start defining its own set of stress testing parameters.
Following the GFC, Stress tests were primarily used to gauge the size of the capital depletion in bank balance sheets, and they were key elements in determining how much additional capital should be provided. This helped to reduce uncertainty, calm the markets and provide extensive disclosure, supporting a more consistent assessment of the risks stemming from both the individual banks’ management and the contagion effect implied in the financial sector.
From 2014, stress tests contributed to the assessment that preceded the consolidation of European banking supervision; they helped levelling the playing field for banks from 19 countries with different accounting rules and supervisory practices.
Historically, the EBA EU-wide Stress Test has covered numerous “stress episodes” and served different purposes, always addressing the challenges of the period. The stress testing started during the GFC which, together with the EU Sovereign Debt Crisis, induced a consolidation of the European banking sector. This was followed by a period of low interest rates coupled with lower growth, which caused concerns for banks’ earnings. Then the Covid-19 crisis came and now the Russian invasion of Ukraine.
During these events, the EU-wide stress test helped to identify potential weaknesses of the EU banking sector and to underpin financial stability considerations and policy. It has been an important tool to induce better risk management practices and risk awareness within the banking industry.
A turning point in the EU-wide Stress Test history has been the introduction of the IFRS 9 Reporting Standard on the 1st January 2018: for institutions that have been reporting under IFRS 9 since 2018, the EU-wide stress test started considering the impact of the introduction of the new accounting regime in starting point data as well as in projections.
In terms of risk coverage, the EU-wide Stress Tests requirements have also been evolving: initially (2014) the only risks included were Credit risk and Market risk whilst since 2016 the risks coverage has been enlarged to:
- Credit risk, including securitizations and sovereign risk
- Market risk (including sovereign risk), CCR and CVA
- Operational risk, including conduct risk
- Net interest income
Regardless the specific period and scope of each EU-wide Stress Test, the exercise is one of the essential regulatory tools for:
- Identifying risks vulnerability in the banking system;
- Assessing the resilience of banks to adverse development;
- Supporting the supervisory decisions with regard to capital and mitigation actions;
- Supporting and fostering better risk management capabilities – including models, data quality and risk management practices;
- Strengthening market discipline by enhancing transparency and comparability across banks.
Overall, these key objectives help ensuring that banks, supervisors, investors and the public are better positioned for the next challenge.