Eurozone Banks Have Inadequate Stress Testing Methods

Saturday, November 29, 2008

A new report published by the European Central Bank (ECB) arrives at the conclusion that the stress testing methods of Eurozone banks are inadequate and have been introduced in some cases only after the beginning of the credit crisis in August 2007.
The report on "EU Banks' Liquidity Stress Testing and Contingency Funding Plans" carried out by the ECB's Banking Supervision Committee arrives at the sour conclusion,
that there is substantial room for improvement in both areas.
Surveying 84 Eurozone banks the ECB said that there was no common standard for the stress testing methods which were insufficient for the majority of banks.
The most common scenarios in liquidity stress tests are idiosyncratic scenarios and market scenarios, although not all banks run both types of scenario. Only a sizeable minority run integrated market and idiosyncratic scenarios.
Highlighting the shortcomings of most banks' stress tests the report points to a lack of different time frames.
Most banks run stress test scenarios that cover either short-term (e.g. four-week) or longer- term (e.g. 12-month) horizons, but only a few test market scenarios with both short and longer-term horizons. The BSC highlights the need for scenarios to be tested for all time horizons which are relevant to banks’ maturity proļ¬les and vulnerabilities.
Another major point for the ECB is the fact that almost all banks disregard cross-border flow problems. Admitting more than a year after beginning of the credit crisis that we are in a crisis situation, the ECB warns that such risks are particularly prevalent in these times.
... Banks do not always include potential barriers to the cross-border flow of liquidity in their stress tests, even though these can be particularly prevalent in crisis situations. In the face of potential barriers to the cross-border flow of liquidity and collateral, the BSC regards running stress tests at both the group and the entity level and accounting for these potential barriers in liquidity stress tests and contingency funding plans (CFPs) as improvements on current practice.
Shareholders Rights Are Secondary
Secretiveness on behalf of the banks is another problem that impedes a comparison of stress tests and their outcomes. The ECB proposes concerted stress tests for Eurozone banks. Proper information policy is not encouraged, though. The ECB recognizes the fact that early publication of banks' liquidity problems may aggravate the survival chances of a bank while paying only lip-service to shareholders information rights.
Banks are reluctant to disclose the results of their liquidity stress tests (apart from to supervisors, rating agencies and some key counterparties) because the results cannot be interpreted without a detailed understanding of the scenarios and the considerations underlying them. The results are therefore not comparable across banks. In addition, public disclosure could have negative repercussions on the liquidity situation of some banks under certain circumstances. While more disclosure, in particular on banks’ liquidity risk management, is generally to be encouraged, the BSC considers that, in the case of liquidity stress test results, the detrimental effects of mandatory public disclosure are likely to outweigh the benefits. Nevertheless, a majority of banks also regard public disclosure in this area as a tool for enhancing market discipline, subject to certain preconditions. In this respect, concerted rounds of common liquidity stress tests – which are conducted, for example, for supervisory/financial stability purposes without affecting banks’ routine liquidity stress tests for internal purposes – would help to increase the comparability of the output of internal models across banks.
The ECB did not find more encouraging practices concerning contingency fund plans (CFP.) As with stress tests there is no ideal CFP that would be applicable to all banks. But there is a lot of room for improvement, it noted.
The typology of EU banks’ CFPs is highly diverse, both in terms of their level of detail and their exact components. The typical CFP consists of a set of liquidity measures, internal procedures, responsibilities and lines of authority to be activated under liquidity stress. CFPs exist at the group level and/or the entity level, but many CFPs seem to cover only parts of the organisation, both in terms of geographic exposure and business areas.
... Given the diversity and complexity of practices, supervisors and central banks need to enhance their understanding of individual CFPs.
With banks being more equal than other corporations the ECB signals political willingness to support money centre banks in case of seizing money markets. This still leaves some other risks, though.
In the BSC’s opinion, it is also important that CFPs take into account potentially destabilising second-round effects on markets from liquidity-saving measures and/or asset sales, particularly in the case of large institutions.
No Quick Fix
Summarizing its survey results the ECB sees no quick fix although exactly that would be needed to mitigate the current crisis that is still on a steep downward path.
Although recent events indicate that CFPs have proved useful in establishing chains of command, a large number of banks failed to activate their CFPs. In some cases, this was blamed on the reputational costs of doing so.
The BSC considers it important that potential reputational challenges associated with the activation of CFPs be overcome, as otherwise they substantially reduce the usefulness of an important liquidity crisis management tool.
While most of the areas in need of improvement identified by the BSC could be addressed in the short term, it is likely that improvements addressing best-practice model developments (such as the inclusion of second-round effects or more integrated views of liquidity, credit and market risk) or the adoption of guidelines can be addressed only in the medium term.

Plans for contingency funding revolve around the all too well known phenomenon of creating more debt. While asset sales lead the list of instruments in an emergency all other options are debt based. I am not very confident that this will work in credit markets that are essentially seized up and show no sign of improvement.
While it is nice to read that the ECB finally acknowledges the sad reality that the crisis has not eased since its beginning 15 months earlier the spotlight is on the banks' inadequate preparedness for a major credit default that must be waiting around the corner given the continuing nervousness and distrust among lenders in the interbank market.

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