Pandemic, inflation, turnaround in interest rates – Europe’s banks have been under constant stress for years. But are capital buffers sufficient for crisis scenarios that have not yet materialized? Financial institutions in the European Union had to do a lot of calculations again in the past few months. The results are now in: the industry is well prepared for a crisis, but some of the large German banks are far down the rankings.
What is a stress test about?
With such tests, bank supervisors want to find out how well financial institutions are prepared for economic and financial shocks. Risks in the balance sheet and weaknesses in the business model should be disclosed as early as possible so that countermeasures can be taken in good time. As a result of such tests, supervisors could, for example, require individual financial institutions to hold more capital in order to be able to better buffer possible future crises.
Since the global financial and economic crisis of 2008/2009, supervisors around the world have been regularly using stress tests to determine how vulnerable banks would be in the event of a crisis. Financial institutions have to prove that they have sufficient capital to continue their business even under adverse circumstances – such as an economic downturn, a crash in real estate prices or increasing loan defaults.
What does that mean when applied to private households?
Applied to consumers, such a test could look like this: Are the income, savings or insurance cover sufficient even if the car and washing machine break down at the same time, the employer goes bankrupt and you don’t find a new job until next year? Or aimed at homeowners: what if lightning struck, the electricity went out, there was a burst water pipe and burglars got into your own four walls at the same time?
How many financial institutions have Europe’s supervisors investigated this time?
The European Banking Authority (EBA) had asked 70 institutions to calculate whether their capital buffers would be sufficient even in the event of a severe crisis. Banks from 15 EU countries plus the largest Norwegian bank DNB were taken into account. According to the EBA, these financial institutions account for around 75 percent of the banking market in the EU and Norway. 57 of the 70 institutions in the EBA stress test are banks from the euro area and are therefore under the direct supervision of the ECB. At the same time, the ECB subjected a further 41 medium-sized financial institutions that it supervises to a stress test. That was one less than advertised.
Which institutes from Germany took part in the tests?
The following institutes in Germany were part of the EBA test: Bayerische Landesbank, Commerzbank, Deutsche Apotheker- und Ärztebank (Apo-Bank), Deutsche Bank, DZ Bank, Landesbank Baden-Württemberg (LBBW), Landesbank Hessen-Thüringen (Helaba), Norddeutsche Landesbank (Nord LB), Volkswagen Bank and Germany’s largest German savings bank, Hamburger Haspa. In addition, several German-based subsidiaries of US banks had to go through the EBA test.
The ECB test had to face: the real estate financier Aareal Bank, the savings bank securities house Dekabank, MünchenerHyp, Hamburg Commercial Bank, which emerged from the Landesbank von Hamburg und Schleswig-Holstein, Deutsche Pfandbriefbank, which emerged from the bankrupt HRE, the holding company of the Landesbank Berlin (LBB).
What exactly was checked?
An intensification of geopolitical tensions was assumed to be accompanied by a resurgence of the corona pandemic. In a crisis scenario, a slump in economic output, rising unemployment and high inflation come together. In the crisis scenario, a slump in the economic output (GDP) of the EU countries in the years 2023 to 2025 by a total of 6 percent was assumed. The EBA had declared that the assumed decline was stronger than in any previous stress test. The unemployment rate rose by 6.1 percentage points during the simulated crisis. The inflation rate was up to 3 percentage points higher than it would have been without the crisis.
What value do overseers pay particular attention to?
It is crucial that banks have enough Common Equity Tier 1 capital. This is capital that is freely available in the event of losses. However, the supervisors did not set a minimum quota this time either. In other words, banks were basically unable to fail this year’s stress tests either. The results flow into the Srep process (“Supervisory Review and Evaluation Process”), in which the viability of business models and the appropriateness of risk management are evaluated. On this basis, the supervisors can instruct individual banks to strengthen their capital buffers.
How did the banks perform in the previous EBA stress test?
Overall, the capital buffers of most financial institutions proved to be resilient under the most adverse conditions. In the simulated crisis scenario of the 2023 stress test, the banks’ Common Equity Tier 1 capital ratio would shrink from 15 percent at the end of 2022 to 10.4 percent by 2025. Although this year’s test was tougher than the previous one from 2021, according to the EBA, the industry did slightly better this time. However, the values are not exactly comparable, also because the EBA examined 20 more institutes this time than two years ago.
Quite a few German banks ended up below average in the 2023 EBA test. This time things went particularly badly for DZ Bank, the leading cooperative institute. However, she pointed out that she would have done better under the new IFRS 17 accounting standard, which has been in force for her since 2023. The Landesbank Hessen-Thüringen (Helaba) and the Norddeutsche Landesbank are also far down in the ranking. Despite a better performance than two years ago, Deutsche Bank was also well below the European average.
What do such tests bring?
They are not undisputed, because which risks are weighted and how heavily in the hypothetical scenarios is ultimately in the hands of the supervisors. Instead of such a general test, some bankers think it makes more sense to do arithmetic exercises that are specific to the topic: for example, on the subject of climate risks in the balance sheets. The ECB carried out the first major climate stress test for banks in 2022.
