We are huge fans of stress tests. In many ways, they are the best macroprudential tool we have for reducing the frequency and severity of financial crises.
The idea behind stress tests is simple: see if all financial institutions can simultaneously withstand a major negative macroeconomic event—a big fall in real output, a large decline in equity and property prices, a substantial widening of interest-rate spreads, an adverse move in the exchange rate. And, importantly, assume that in response to these adverse circumstances banks have no way to sell assets or raise equity. That is, the stress test asks whether each intermediary can stand on its own without help in the middle of an economic maelstrom. But for stress tests to be effective, they must be truly stressful. The tempest has to be the financial equivalent of a severe hurricane, not just a tropical storm.
This brings us to the latest European Banking Authority (EBA) 2016 stress tests. As we mentioned recently, the European financial system may be the biggest source of systemic risk globally. So, these tests are important not just for Europe, but for the world as a whole. Unfortunately, they just aren’t severe enough, so there is little reason to be confident about the resilience of European finance.
To summarize the published results, the EBA concludes that, with the exception of Deutsche Bank, all of the largest European institutions meet the 3% leverage ratio requirement throughout the three-year simulated stress episode. And, at 2.96%, even Deutsche Bank comes close. But, as we see it, a capital-asset ratio of 3% probably isn’t sufficient to avoid runs in a crisis. While these banks may meet a weak regulatory test, as the more than 40% decline of bank equities over the past year implies, they do not meet the market test. (Deutsche Bank’s stock price-to-book ratio is currently less than 0.25, with the remainder of the largest banks examined at less than 0.75.) And beyond that, there is good reason to doubt that banks are as well capitalized as the EBA’s results indicate.
Let’s compare the EBA stress scenario to those used by the Bank of England and the Federal Reserve. We start with the difference in their assumptions about equity market performance. In the EBA’s severe scenario, European equity prices drop by only a bit more than 25%. In contrast, the Bank of England assumes that the U.K. and U.S. equity markets both fall by more than 40%, while the Federal Reserve’s severely adverse scenario builds in a 51% crash in the Dow Jones Industrial Average. The U.K. and U.S. tests are both consistent with the plunge of more than 40% in global equities that actually occurred in 2008. The European test is not. (For the record, to make comparisons such as these straightforward, we advocate a common and exhaustive disclosure standard for both the scenarios and the results of regulatory stress tests.)
The table below shows that property price assumptions used by the EBA also appear relatively benign. While we do not have comparable data for the U.S. test, the Bank of England’s stress scenario assumes that residential and prime commercial property prices in the United Kingdom will fall by much more than the EBA assumes they will.